This study search to investigate the relationship between credit risk, measured by S&P longtermdomestic issuer credit rating, and stock returns. Analyzing 3,172 companies over theperiod January 1985 to December 2013 we investigate if it exist a relationship using severalmethods. In the first part we generate portfolios sorted by credit rating, and analyze howcertain firm characteristics and returns varies between good and bad rated stocks. Secondly,we are running panel data regressions on individual securities controlling for several controlvariables, such as book-to-market, market value of equity, and share turnover. We find anegative relationship between stock returns and credit ratings, suggesting that worst ratedstocks on average yield lower returns than better-rated stocks. Market value of equitydecrease monotonously as rating deteriorates. However, we also find that the credit ratingeffect is related to worst rated stocks. Excluding the worse rated stocks, we find no statisticalevidence that there exist a negative effect, until we include BB- rated stocks. In times ofrecession the effect is stronger than in expansions, suggesting that credit ratings may be ofmore interest for investors when there exist a higher risk of financial distress. Arounddowngrades (upgrades) returns have a downward (upward) trend ex-ante the event. Afterchange in credit quality, we notice returns bounce back on a level equal securities that did notexperience any rating action. It is no clear explanation to this negative relationship. Existingliterature suggest that majority shareholders can extract private benefits from distressedcompanies, buying the companies assets or output at lower price. Hence, the observed returnis lower than the realized return. For smaller companies with low analyst coverage, bad newstravel more slowly than in large firms with higher analyst coverage, and theunderperformance can be explained due to investor’s underreaction to negative information.
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