The Academy of Financial Services 35th Annual Meeting

Credit watch, credit ratings, capital structure

Through examination of the relationship between rating levels and subsequent annual net debt changes, Kisgen (2006) provides support for the Credit Rationing – Capital Structure (CR-CS) hypothesis which maintains that “+” or “-“ notch firms are more likely than non-notch firms to reduce net debt levels to increase the likelihood of a beneficial rating change.  Through focusing on quarterly net debt changes over the two years before and after rating changes, we show that notch firms are generally not associated with lower net debt levels, greater net debt reductions, or higher probability of upgrades than non-notch firms before rating changes.  Instead, notch firms with CreditWatch (CW) announcements are associated with relatively greater net debt level increases beginning three quarters before rating changes and these increases continue for firms both without and with CW announcements after the rating change.  Further, analysis of upgrades-to-downgrades (UP/DOWN) at the time of rating change reveals that UP/DOWN is more a function of the presence of prior CW announcements than notch status.  Firms without and with CW announcements exhibit UP/DOWN ratios of .8455 and .3628, respectively, with no significant differences in these ratios between notch and non-notch firms.