The Valuation and Contracting Roles of Credit Watches

This study analyzes 3,992 credit watches and 8,318 rating changes covering 14 years from 1992 through 2005 using data from Moody's Default Risk Service. We examine the information role of credit watches, and test whether credit rating agencies (CRAs) issue credit watches as a way to facilitate the use of credit ratings in contracting. By issuing a credit watch, a CRA can convey new information about credit quality, but at the same time delay the issuance of an actual rating change until a definitive change in an issuer's credit quality has occurred. As a result, rating stability is increased. We observe strongly significant three-day cumulative abnormal returns (CARs) surrounding credit watch start dates. Also, the market response to watch actions is positively associated with the direction of future rating changes after controlling for potentially relevant explanatory variables. We also find that the likelihood that a ratings change is preceded by a credit watch is positively associated with proxies for investor demand for credit quality information. We then examine the role of credit watches in contracting, Our first analysis indicates that rating changes are relatively more likely to be preceded by watch actions when the potential benefit of delaying the rating change and/or the potential cost of a subsequent rating reversal are largest, for example, when the rating change is multinotch. A final result is that, consistent with both the valuation and contracting roles of credit watches, credit watches are issued when the total market effects of the new credit quality information are relatively large.