What Drives Credit Rating Changes? A Return Decomposition Approach

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, I use a Vector Autoregressive (VAR) model to implement the return decomposition of Campbell and Shiller (1988) and Vuolteenaho (2002) to extract cash-flow news and discount-rate news from stock returns at the firm level. I 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-return news. I 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 symmetric 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.