Monday, January 23, 2012

Stocks dance to downgrade tune

This article was published in the Hindu Business Line on 23rd January 2012. The link is

Credit Rating Agencies (CRAs) have been around since more than a century. In India, the first CRA CRISIL was started in collaboration with the international CRA Standard & Poor's (S&P) in 1988.

The role of the CRAs has been important in the investors' decision making process. However, international credit rating agencies like Moody's, S&P and Fitch have been under the scanner in the last decade for failing to signal the downfall of giants like Merrill Lynch (2007) and Enron (2001). The incorrect high ratings for these giants resulted in loss of credibility of these agencies.


The Indian counterparts CRISIL, ICRA, FITCH, CARE and Brickworks are known to be relatively more conservative in their ratings. Maybe that is the reason why there have been only cases of rating upgrades amongst all NSE-listed companies in the last decade.

My friends, Chakrapani Chaturvedula and Nikhil Rastogi, from IMT Hyderabad and I studied the credit rating changes by CRISIL, ICRA, FITCH and CARE in all the NSE-listed companies for the last ten years.

We investigated the impact of credit rating changes viz. upgrades, downgrades, reaffirmations, withdrawals and initiations on the stock prices of the respective companies.

These ratings are supposed to convey the future prospects of the company and other relevant information about the company to the investors. They are supposed to act as “independent auditors” who provide a “certificate of creditworthiness” to the companies.

The companies have a tendency to delay the release of negative information or hide them. And since the reputation of the agencies is more at stake in case of incorrect higher ratings, they spend more resources to find negative information about companies. In such a scenario, a downgrade by an agency is of immense importance to the investors in their decision making process.

We find that downgrades result in significant abnormal losses (due to selling pressure) for the investors. The graph shows a downward trend for the cumulative abnormal returns after the event. We see that from the day of the downgrade (day zero), the prices fall almost 5 per cent on an average in the next 10 days.


The result of our study is also evident in a recent event when Moody's downgraded the outlook of the Indian banking system from ‘stable' to ‘negative'. We saw the banking stocks lose heavily in the days to follow.

Within the next 10 working days, the CNX Bank index had fallen by 16 per cent. Apart from downgrades, no other actions by the credit rating agencies had any impact on the stock prices.

Contrary to our expectations, we find that there is no significant negative impact of withdrawal and no significant positive impact of initiation on the stock prices.

These could be because the market might have already anticipated withdrawals and initiations much before the actual act.

Hence, on the day and after the day of the act, there is no new information being brought into the market. The number of upgrades (only 10) during the period was too few to meaningfully conclude anything.

Continuing with the story of the outlook for the banking system in India, S&P actually upgraded the rating of the Indian banking system just the day after the Moody's downgrade. In spite of that, the banking sector stocks continued their downward slide.

This once again showed that the market reacts to bad news swiftly in order to avoid losses. But it does not react to good news in the same magnitude.

With SEBI seeking more disclosures from the CRAs on the factors and process which results in the ratings, we anticipate that the rating changes will become more meaningful in the future as investors will then be able to make more informed decisions, especially in the case of conflicting ratings from different agencies.