ARE SHORT SELLERS INFORMED? EVIDENCE FROM CREDIT RATING AGENCY ANNOUNCEMENTS

• Published date: 01 June 2017
• Author: Jian Shi,Junbo Wang,Ting Zhang
• Date: 01 June 2017
• DOI: http://doi.org/10.1111/jfir.12121

ARE SHORT SELLERS INFORMED? EVIDENCE FROM CREDIT RATING

AGENCY ANNOUNCEMENTS

Jian Shi

Bank of America/Merrill Lynch

Junbo Wang

City University of Hong Kong

Ting Zhang

University of Dayton

Abstract

Although constrained by rules and regulations, informed short selling (tipping) is present

before negative credit watch and certain types of rating downgrade announcements.Using

entity credit rating and daily short sale data from April 2004 to December 2009, we find that

preannouncement abnormal short selling significantly increases toward the announcement

dates and isnegatively related to postannouncement stock returns. Furthermore, short selling

driven by tipping is more pronounced before more severe and more surprising rating

downgrades. This study provides evidence favoring the private information hypothesis

(tipping) in the ongoing debate of the informational advantage of short sellers.

JEL Classification: G12, G14, G24

I. Introduction

Credit rating agencies (CRAs) such as Moody’s Investors Service, Standard & Poor’s

(S&P), and Fitch Ratings

1

assess the creditworthiness of entities and their debt

obligations. These assessments are made public through credit rating announcements.

Initially, CRA rating announcements were mainly about rating changes, such as rating

downgrades and upgrades. Since 1981, however, the credit watch procedure

2

has been

introduced to complement the formal rating process. An obligor is placed on credit watch

for possible future upgrade, downgrade, or uncertain direction when its credit quality has

changed to a point where its rating needs to be revised (Hamilton and Cantor 2004, 2005).

We are grateful to the editors and an anonymous referee for their insightful comments and suggestions. Junbo

Wang acknowledges financial support from the City University Strategic Research Grant (Projects 7004258,

7004766, and 7004525), from the Research Grants Council (RGC) research grant (Project 9041965, equivalent to

CityU 194913) of Hong Kong Special Administration Region, and from the research grant of National Science

Foundation of China (NSFC) (No. 71528001). The views expressed in this paper are those of the authors and do not

necessarily reflect the position of Bank of America/Merrill Lynch.

1

Among CRAs, certified CRAs are also known as nationally recognized statistical ratings organizations

(NRSROs). There are also noncertified CRAs servicing both the United States and the international markets.

2

A credit watch is also known as a credit watch placement, credit review, or credit warning.

The Journal of Financial Research Vol. XL, No. 2 Pages 179–221 Summer 2017

179

© 2017 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

The combination of credit watch and rating change has become the centerpiece of a

CRA’s institutional rating mechanism. These rating announcements not only have a

profound impact on firm financial and capital structure decisions, but also can change

how markets value firm debt and equity. We focus on the equity market and study short

selling and price reactions around credit watch placement and rating change

announcements.

Although the empirical evidence is mixed on the market reactions to rating

upgrades,

3

there is much more consensus on how the market reacts to rating

downgrades and negative credit watch placements. The literature documents negative

abnormal stock market reactions to negative CRA announcements (see, e.g., Griffin

and Sanvicente 1982; Holthausen and Leftwich 1986; Hand, Holthausen, and

Leftwich 1992; Dichev and Piotroski 2001; Cantor 2004; Gande and Parsley 2005;

Beaver, Shakespeare, and Soliman 2006; Chakravarty and Lee 2009; Bannier and

Hirsch 2010).

The stock market may react to the negative rating announcements of

a major CRA for several reasons. First, the CRA’s rating decision is at

least partially based on nonpublic informationprovidedbytheratedentity.

4

Therefore, on top of the rating decision release itself, a CRA announcement

may provide additional information that is not already known to the market.

Second, most firms’borrowing costs are largely determined by the credit ratings

of their debts by certified CRAs. Thus, a rating change or indications (by credit

watches) of a rating change affect a company’s future cost of borrowing and thus its

earning ability. Stock prices may be subsequently adjusted once the announcement

is made to account for this anticipated change in the cost of capital. Finally,

credit ratings from certified CRAs have increasingly played a contracting role (see

Beaver, Shakespeare, and Soliman 2006), in which the ratings are explicitly used

to trigger certain clauses in firms’borrowing contracts. For example, if a firm is

downgraded below a certain grade by a certified agency, it can result in a

debt covenant violation and trigger its debt default. Consequently, stock prices

should reflect such (or the increased likelihood of such) events once the rating

decisions are made public. Overall, it is not surprising that a negative CRA

announcement could cause the stock price to drift downward. If a price downfall

3

Most studies have found insignificant or very weak market reaction to rating upgrade news (see, e.g., Griffin

and Sanvicente 1982; Hand, Holthausen, and Leftwich 1992; Dichev and Piotroski 2001; Cantor 2004; Gande and

Parsley 2005; Beaver, Shakespeare, and Soliman 2006; Bannier and Hirsch 2010). However, Jorion, Liu, and Shi

(2005) document a small, but significant, positive abnormal return following the bond upgrades after Regulation

Fair Disclosure was implemented in October 2000.

4

For example, Moody’s 2002 Special Comment (Fons, Cantor, and Mahoney 2002, p. 5) states:

Moody’swilluseconfidential non-public information that issuers provide to Moody’s only for the purpose of

assigning ratings. Moody’s will not, without the permission of the issuer, disclose the information in the press

release or other research reports published in connection with the rating, or in discussions between Moody’s

analystsandinvestors,orotherissuers....Moody’sbelievesthattheefficiency of capital markets is best

served by permitting issuers to disclose to rating agencies material non-public information for use solely in

rating decisions.

180 The Journal of Financial Research

can be anticipated, a profit may be made by establishing short positions before the

negative announcement.

5

The model proposed by Diamond and Verrecchia (1987) contends that given the

high short sale costs, shortsellers must have an edge to overcome these costs to participate

in trading profitably. This impliesthat short sellers are likely to possess superior ability in

forecasting future stock returns. Consistent with this view, the recent literature provides

extensive empirical evidencethat high levels of short sales or short interests lead to future

stock price underperformance (Desai et al. 2002; Asquith, Pathak, and Ritter 2005;

Boehmer,Jones, and Zhang 2008). However, there is not muchagreement on how the short

sellers are able to predictfuture stock returns. The current literatureoffers two major lines

of explanations:the public and private information hypotheses. Thefirst hypothesis is that

short sellers are sophisticated investors and are capable of processing publicly available

information accurately and efficiently.

6

The alternative explanation to short sellers’

advantage is that they are able to obtain private information that is not accessible to all

market participantsand thus gain an information advantage over other market participants

(e.g., Christophe, Ferri, and Hsieh 2010; Anderson, Reeb, and Zhao 2012).

The possibility of the private-information-driven short selling before CRA

announcements is exemplified by the recent episode of the S&P’s U.S. government debt

downgrade. According to the Wall Street Journal, the U.S. Securities and Exchange

Commission (SEC) started an investigation on possible insider trading and information

leakage before the downgrade announcement was made.

7

This anecdotal evidence calls

attention to the question of whether private information contributes to short selling before

CRA announcements.

A potential counterargument to the private information explanation is that the

existing regulations and legislations remove insiders’information advantage and/or

prevent them from using insider information.

8

In the case of CRA announcements,

attempts to obtain private information may be further thwarted because both legislation

9

5

Some research has studied the timeliness of CRA announcements made by certified versus noncertified

agencies. For example, Beaver, Shakespeare, and Soliman (2006) argue that Moody’s moderately lags those of

noncertified CRAs, such as Eagon Jones Rating in downgrade decisions, and severely lags in upgrade decisions.

However, timeliness is mainly related to the valuation information provided to the market. Therefore, even if a

certified CRA’s rating decision is less timely than a noncertified rating decision, the market could still react to the

former for other reasons discussed in this paragraph (such as contracting roles), which potentially creates profitable

opportunities for investors who can successfully predict the direction of price changes.

6

For example, Engelberg, Reed, and Ringgenberg (2012) use a short sale data set combined with a large set of

news releases and argue that short sellers’trading advantage mainly comes from their abilities to quickly and

effectively process the public information. Desai, Krishnamurthy, and Venkataraman (2006) study a specific type

of news and show that short selling before earning restatements is, at least in part, related to the public information

conveyed by accruals.

7

The SEC asked S&P to provide a list of its employees who may have had access to the downgrade decision

before the announcement (Jean Eaglesham and Jeannette Neumann, “SEC Checks S&P’s Downgrade Math,”Wall

Street Journal, August 12, 2011). In addition, the SEC subpoenaed hedge funds and other trading firms to probe

possible insider trading before the U.S. credit rating downgrade announcement (Jean Eaglesham, “U.S. Probes

Rating-Cut Trades-Regulators Subpoena Hedge Funds, Others Over Actions Ahead of S&P Downgrade,”Wall

Street Journal, September 20, 2011).

8

For example, Regulation Fair Disclosure requires broader information flow to the capital market and may

therefore help reduce the advantage of insider information.

Are Short Sellers Informed? 181