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The paper, co-written by Omri Even-Tov of Berkeley Haas and Naim Bugra Ozel of the Wharton School and the Univeristy of Texas at Dalla, highlights a potential concern for investors, credit issuers, and the Securities and Exchange Commission, tasked with ensuring fair rating information to all market participants. The paper is forthcoming in the Review of Accounting Studies.
“Our evidence suggests that some rating analysts share confidential information about upcoming rating changes with institutional investors, for whom they later go to work,” said Even-Tov. “This is not only problematic for investors whose trades may be front-run by those with advance knowledge of rating changes, but also for credit issuers who share private information with the credit agencies, since it may not stay private for long.”
Our evidence suggests that some rating analysts share confidential information about upcoming rating changes with institutional investors, for whom they later go to work.
Price movements before announcements
Even-Tov and Ozel examined how companies’ stock prices fluctuate before public announcements of their credit ratings. They found that stock prices start moving in the direction of upcoming downgrade announcements even when there is no other news about the stock.
“Before rating agencies make public announcements about rating changes, they first privately notify the issuing company,” Even-Tov says. “We set out to study whether there is informed trading between the private notification and the public announcement, which is typically no more than 48 hours.”
The researchers examined more than 1,000 credit rating change announcements from the three major reporting agencies—S&P, Moody’s, and Fitch—between 2001 to 2017. They combined this with data on intraday stock returns, which allowed them to see how stock prices fluctuated within short time periods.
In line with prior research, they found significant, but modest, stock price changes immediately after credit rating announcements, particularly for rating downgrades. In the two hours following a downgrade announcement, stock prices declined by between 0.1% and 0.9%. Stock prices increased by about 0.1% to 0.2% following a rating upgrade.
Interestingly, these returns were modest in part because of large stock movements that came before the official rating was publicly announced. In the 48 hours before an announcement—a period when the rating report is typically finalized and forwarded to credit issuers for review before publication—they found that stock prices declined by up to 1.5% for a rating downgrade and increased by up to 0.4% for a rating upgrade. Institutional investors tend to be net sellers in the 48 hours ahead of downgrades.
Even-Tov and Ozel looked at the factors that might explain these pre-announcement stock returns and whether there was any evidence of informed trading. Many rating announcements occur after other important corporate news events, such as earnings or merger announcements, which could drive stock price changes. When the authors removed such announcements from their data, they still found significant price changes within the 48-hour pre-announcement window (and not prior to that period).
They then looked at whether investors may have anticipated credit rating announcements based on other publicly available information. They found that corporate news and investor anticipation explained pre-announcement movements for rating upgrades, but still could not fully explain stock movements before rating downgrades.
Looking for signs of informed trading
A third explanation for stock movements immediately prior to rating announcements is that some form of informed trading is occurring. This is of course illegal, and insider trading can lead to financial penalties or jail time.
Even-Tov and Ozel scrutinized the analysts named in credit announcements and whether they possibly passed along information to institutional investors. They separated out those who stayed with their credit agencies from those who later switched jobs to an asset management firm. They found that pre-announcement returns are significantly stronger when one or more of the credit analysts who prepared the report later pursues a career in the asset management industry. In those cases, stock returns were 2% lower in the 48-hours before the downgrade announcement. Moreover, they also found that institutional investors are those who benefit in these cases—they are net sellers. In contrast, they found insignificant returns if the analyst stayed with the reporting agency.
In contrast, they did not find any evidence that insiders from the issuers traded on information about upcoming rating changes—in fact, they found that insiders generally reduce their trading in the sensitive period ahead of downgrades, perhaps out of fear of running afoul of regulators. That further implies that the leaked information from analysts drives stock returns.
Our paper shows yet another example of the revolving door on Wall Street, which should draw the attention of the SEC and credit agencies.
“Our paper shows yet another example of the revolving door on Wall Street, which should draw the attention of the SEC and credit agencies, says Even-Tov.
