The investment universe includes stocks from Compustat and CRSP, with transaction data from Abel/Noser Corporation and credit ratings from Egan-Jones, S&P, Moody’s, and Fitch, focusing on institutional investors.
ASSET CLASS: stocks | REGION: United States | FREQUENCY:
Monthly | MARKET: equities | KEYWORD: Credit Rating, Announcements
I. STRATEGY IN A NUTSHELL
The strategy examines stocks from Compustat and CRSP, integrating transaction-level data and credit ratings from multiple agencies (EJR, S&P, Moody’s, Fitch). Focusing on institutional investors, it evaluates how they respond to credit rating changes, highlighting the impact of both issuer-paid and investor-paid ratings on stock holdings.
II. ECONOMIC RATIONALE
Institutional investors react differently to credit ratings based on the source. They reduce holdings after investor-paid downgrades, which are more timely and unbiased, but largely ignore issuer-paid downgrades. Upgrades, particularly issuer-paid, prompt attention. The strategy exploits this differential response, leveraging the timeliness and credibility of ratings to inform profitable investment decisions aligned with professional investor behavior.
III. SOURCE PAPER
Asymmetric Trading Responses to Credit Rating Announcements from Issuer- versus Investor-Paid Rating Agencies [Click to Open PDF]
Pham Minh Quan Nguyen, School of Economics and Finance, Massey University, New Zealand; Hung Xuan Do, UQ Business School, University of Queensland, Australia; Alexander Molchanov, Finance Department, Auckland University of Technology, New Zealand; Lily Nguyen, School of Economics and Finance, Massey University, New Zealand; Nhut (Nick) Hoang Nguyen, School of Economics and Finance, Massey University, New Zealand
<Abstract>
Credit rating industry business model has traditionally been based on an ‘issuer-pays’ principle. Issuer-paid credit rating agencies (CRAs) have recently faced criticism regarding untimely releases of negative ratings adjustments, which is attributed to conflict of interest of their business model. A model based on ‘investor-pays’ principle is arguably free of such conflict. We examine how institutional investors respond to changes in credit ratings issued by these two types of CRAs. We find that investors react asymmetrically: They abnormally sell equity stakes around rating downgrades by investor-paid CRAs, while abnormally buying around rating upgrades by issuer-paid CRAs. Further, a dynamic trading strategy based on such trading behavior generates significant abnormal returns. Our study suggests that, through their trades, institutional investors capitalize on value-relevant information provided by both types of credit rating agencies.
IV. BACKTEST PERFORMANCE
| Annualised Return | 22.04% |
| Volatility | 13.2% |
| Beta | N/A |
| Sharpe Ratio | 1.67 |
| Sortino Ratio | N/A |
| Maximum Drawdown | N/A |
| Win Rate | N/A |
