Credit Ratings and Market Dynamics

Rating agencies provide opinions on the creditworthiness of companies and debt instruments, and so reduce lenders’ information gathering costs. Their ratings are especially useful in distinguishing the relative riskiness of different borrowers. Empirical evidence suggests that rating agencies rank the riskiness of borrowers well: realised default rates are consistently higher for lower rating grades. Over the past few years, however, the performance of rating agencies has been widely debated. Concerns have been expressed about the timeliness and predictive accuracy of ratings – issues that have received greater attention internationally following the high-profile collapses of Enron and WorldCom in the United States. Similar scenarios have arisen in Australia too: HIH Insurance had an investment-grade rating only a few weeks before it became insolvent (Graph 1). Such concerns have prompted some observers to question the value of the rating agencies, and to suggest that their opinions do not contain information beyond what is already available to debt and equity market participants. This is a proposition that can be tested by examining how changes in ratings affect financial market prices. Such tests also shed light on rating agencies’ contribution to the dynamics of market pricing. This article presents evidence on the response of security prices to credit rating changes in Australia.