In Practice Ratings Changes and Interest Rates

The rating assigned to a company can change at the discretion of the ratings agency. The change is usually triggered by a change in a firm's operating health, a new security issue by the firm or by new borrowing. Other things remaining equal, ratings will drop if the operating performance deteriorates or if the firm borrows substantially more and improve if it reports better earnings or if it raises new equity. In either case, though, the ratings agency is reacting to news that the rest of the market also receives. In fact, ratings agencies deliberate before making ratings changes, often putting a firm on a credit watch list before changing its ratings. Since markets can react instantaneously, it should come as no surprise that bond prices often decline before a ratings drop and increase before a ratings increase. In fact, studies indicate that much of the bond price reaction to deteriorating credit quality precedes a ratings drop.

This does not mean that there is no information in a ratings change. When ratings are changed, the market still reacts but the reactions tend to be small. The biggest service provided by ratings agencies may be in providing a measure of default risk that is comparable across hundreds of rated firms, thus allowing bond investors a simple way of categorizing their potential investments.

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