What Drives Credit Rating Changes? A Return Decomposition Approach

• DOI: http://doi.org/10.1111/ajfs.12118
• Published date: 01 December 2015
• Date: 01 December 2015

What Drives Credit Rating Changes? A

Return Decomposition Approach*

Hyungjin Cho**

Department of Business Administration, Universidad Carlos III de Madrid

Sunhwa Choi

Management School, Lancaster University

Received 13 April 2015; Accepted 18 November 2015

Abstract

This paper examines the relative importance of a shock to expected cash flows (i.e., cash-flow

news) and a shock to expected discount rates (i.e., discount-rate news) in credit rating

changes. Specifically, we use a Vector Autoregressive model to implement the return decom-

position of Campbell and Shiller (Review of Financial Studies, 1, 1988, 195) and Vuolteenaho

(Journal of Finance, 57, 2002, 233) to extract cash-flow news and discount-rate news from

stock returns at the firm-level. We find that credit rating changes are, on average, more

strongly associated with cash-flow news than with discount-rate news, consistent with cash-

flow news being more permanent than discount-rate news. We further find that both cash-

flow news and discount-rate news are more strongly related to credit rating changes when

they convey negative information about firm value. This asymmetric association is consistent

with the non-linear nature of default risk and with the fact that rating agencies incorporate

bad news sooner than good news into their rating revisions. This paper contributes to the lit-

erature by providing evidence on the relative importance of cash-flow news and discount-rate

news in the credit rating process.

Keywords Cash-flow news; Credit ratings; Discount-rate news; Return decomposition; Vector

Autoregression

JEL Classification: G12, G24

*We appreciate helpful comments from Bok Baik, Lee-Seok Hwang, Moon Chul Kim, Jong-

chan Park, Steve Young, two anonymous referees, and seminar participants at the Lancaster

University, Nanyang Technological University, Seoul National University, and Singapore

Management University.

**Corresponding author: Hyungjin Cho, Departamento de Economia de la Empresa, Univer-

sidad Carlos III de Madrid, Calle Madrid 126, 28903 Getafe, Madrid, Spain. Tel: +(34)-91-

624-9322, Fax: +(34)-91-624-9607, email: cho.hyungjin@uc3m.es

Asia-Pacific Journal of Financial Studies (2016) 44, 899–931 doi:10.1111/ajfs.12118

©2015 Korean Securities Association 899

1. Introduction

Since the price of an asset is equal to the sum of expected cash flows discounted by

appropriate discount rates, there are, by definition, only two sources that can

change asset prices: a shock to expected cash flows (i.e., cash-flow news); and a

shock to expected discount rates (i.e., discount-rate news). In terms of asset returns,

the unexpected return can be decomposed into cash-flow news and discount-rate

news (Campbell and Shiller, 1988). Using this return decomposition framework, a

substantial body of research has examined the relative importance of cash-flow and

discount-rate news in stock returns at the aggregate level (Campbell, 1991; Camp-

bell and Ammer, 1993; Sadka, 2007; Chen et al., 2013) and at the firm-level (Vuol-

teenaho, 2002; Callen and Segal, 2004; Callen et al., 2005; Chen et al., 2013). An

equally important but largely unexplored issue is the effect of cash-flow news and

discount-rate news on the revision of default risk. Because default risk is based on

the distribution of the expected cash flows relative to its outstanding debt (Merton,

1974; Cheng and Subramanyam, 2008), the probability of default should increase

with a negative shock to the expected cash flows and a positive shock to the

expected discount rate (i.e., an increase in the riskiness of expected cash flows). If

so, what is the relative importance of these two components? Under what circum-

stances does the relative importance of these two types of news vary? To date, no

empirical research has addressed these questions. We seek to answer these questions

by examining the relation between the two components of news and credit rating

changes.

An issuer-level corporate credit rating offers a good research opportunity to

address the question of the relative importance of cash-flow news and discount-rate

news in the probability of default.

1

A corporate rating, also called “default risk rat-

ing” or “natural rating”, is a current opinion by rating agencies about an issuer’s

overall capacity to pay its financial obligations based on the assessment of the likeli-

hood of default of the corporation (S&P,2006). This issuer-level rating is different

from an issue-specific credit rating assigned to an individual debt issue because the

former does not reflect any priority among obligations or issue-specific characteris-

tics such as collateral and debt covenants. Additionally, the issuer-leve l rating evalu-

ates the firm’s fundamental creditworthiness with respect to a very long time

1

At first glance, it seems natural to study corporate bond returns to examine the effects of

cash-flow news and discount-rate news on the probability of default. However, it is hard to

use the bond return in this research setting because the bond return, by definition, has a

minimal cash-flow-news component due to its fixed coupon and principal payments. As the

growth rate of cash flows (coupons) is zero when the present value model of Campbell and

Shiller (1988) is applied to bonds, prior studies decompose bond returns into a shock to

future inflation, future real interest rate, and future excess bond return (Shiller and Beltratti,

1992; Campbell and Ammer, 1993; Abhyankar and Gonzalez, 2009). Moreover, the bond has

various issue-specific characteristics such as covenants, collaterals, and priority, making it dif-

ficult to draw inferences with respect to firm-level cash-flow news and discount-rate news.

H. Cho and S. Choi

900 ©2015 Korean Securities Association

horizon, instead of fixed debt maturities (S&P,2006). Using this issuer-level credit

rating change as a proxy for the revision to the probability of default, we examine

the relative importance of cash-flow news and discount-rate news.

A better understanding of the rating process is also important in itself. Despite

the prominent role of credit ratings in the capital market, the rating process has

been viewed more as a “black box” (Cifuentes, 2008). For example, we do not know

much about what types of information are used and how different types of infor-

mation are weighted in the rating process.

2

By investigating the relative weight

given to the two fundamental components of new information in the rating process,

this study enhances our understanding of how rating agencies use various types of

information.

To implement the return decomposition, we adopt the Vector Autoregressive

(VAR) model of Vuolteenaho (2002), which uses return on equity (ROE) as the

basic cash-flow fundamentals. We extract cash-flow news and discount-rate news at

the firm-level from stock returns and then examine whether credit rating changes

are more strongly associated with cash-flow news or with discount-rate news. We

further examine whether cash-flow news and discount-rate news become more rele-

vant in updating the probability of default when the news conveys negative infor-

mation about the firm.

This return decomposition approach offers several advantages in addressing our

research questions for the following reasons. First, the model, derived from a

dynamic accounting identity, provides a convenient and theoretically solid frame-

work to disentangle cash-flow news and discount-rate news components. Second,

the approach enables us to capture long-term and forward-looking information

about the firm, as the news variables are measured from the stock returns, which

reflect the most comprehensive information set. Specifically, cash-flow news is

defined as the shock to the discounted sum of expected current and future earnings

over the lifetime of the firm. Such extension of the horizon to the future periods is

particularly relevant in rating decisions because credit rating agencies emphasize

their long-term perspectives in rating decisions. For example, S&P indicates that

“S&P’s credit ratings are meant to be forward-looking, and their time horizon

extends as far as is analytically foreseeable” (S&P, 2006, p. 33).

3

Finally, by using a

return decomposition approach, cash-flow news and discount-rate news can be

measured in an internally consistent way (i.e., the sum of cash-flow news and dis-

count-rate news equals the unexpected stock return), and thus a researcher can

2

At the hearings of the Securities and Exchange Commission (SEC), credit rating users

stressed the importance of transparency in the rating process. Particularly, they argue that the

market needs to understand the reasoning behind a rating decision and the types of informa-

tion relied upon by the rating agencies (SEC, 2003, p. 33).

3

Similarly, Moody’s corporate ratings are intended to be determined by each issuer’s relative

fundamental creditworthiness without reference to explicit time horizons (Cantor and Mann,

2003).

A Return Decomposition Approach on Credit Rating Changes

©2015 Korean Securities Association 901