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Asian Review of Financial Research Vol.29 No.1 pp.113-148
Information Value of a Credit Watchlist
Junesuh Yi* Professor, Dongguk Business School, Dongguk University
Key Words : Credit Rating,Credit Watch List,Rating Change,Information Delivery,Implicit Contract


This paper analyzes the information value of a credit watchlist in the Korean credit rating market. Credit rating agencies issue credit watches to indicate the direction of ratings changes within a short time horizon of three months on average. Credit watches are marked as either up, down, or uncertain. A watch is usually triggered by discrete corporate events such as mergers, acquisitions, restructuring, and announcements of plans expected to affect credit quality, or by trends in the issuer's operations or financial weaknesses such as financial performance, liquidity and leverage, and accounting fraud. The watchlist either improves the information-certification role of credit ratings (delivering information), or allows rating agencies to influence the risky choices of issuing firms by threatening them with imminent rating downgrades and subsequent investor reactions (implicit contract). This study tests these two different explanatory lines to determine the information value of the credit watchlist. This study also identifies the features of firms with rating changes that are preceded by credit watches, and the factors affecting the agreement between a credit watch and subsequent rating changes. In addition, it examines whether the market reaction to rating changes depends on whether it is preceded by a negative credit watch. It is observed that there is a greater proportion of credit watches marked as “down” in Korea than in the US, and that the credit watchlist has been operated quite conservatively. Using the Nice's credit rating and watchlist data from 2000 to 2014, the results support the delivery of information argument more than the implicit contract argument. Most of the variables that represent delivery of information, such as size, fixed assets, and BBB rating, are statistically significant, whereas the only significant variable associated with an implicit contract is cash ratio. However, the watchlist by provisional evaluation and simultaneous announcement with rating change presents a role of the implicit contract as well as the delivering information A negative watchlist followed by a downgrade is more likely to occur with larger issuers, greater rating changes, and lower credit ratings. Moreover, the extent to which the direction of credit watches coincides with the direction of subsequent rating changes is greater when there is a shorter duration between the watchlist and the rating change, periodical evaluation, and lower credit ratings. In terms of market reactions to downgrades, the negative watch-proceeded downgrades rather than the direct downgrades exhibit greater negative cumulative abnormal returns, which deepen in investment grade, provisional evaluation, and simultaneous announcement of watchlist and rating change. Meanwhile, the issuing firm's cumulative abnormal return is statistically significantly negative when a negative watchlist is issued, but insignificantly positive when a positive watchlist is issued. Therefore, the information value of the credit watchlist can be summarized as follows. First, the watchlist in the Korean credit rating market generally fulfills the delivery of information rather than the implicit contract role. Analysis of the characteristics of firms that are issued with a negative watchlist indicates that the proxies measuring the delivery of information, such as size, fixed assets, and BBB of credit rating, are statistically significant. The role of the implicit contract is also partly observed in that the downgrades are actually executed in less than seventy percent of the issued negative watchlist cases. Furthermore, the credit watches by provisional evaluation and simultaneous announcement with rating change are also observed to present the implicit contract role. Second, the watchlist provides more information about issuers with investment credit ratings than speculative credit ratings. There is a greater deterioration in negative cumulative abnormal returns for investment than for speculative grades when a negative credit watch is issued. This phenomenon also appears when the downgrade is subsequent to a negative credit watch. The watchlist is less likely to be issued to speculative or default credit ratings. Third, the watchlist together with rating changes magnifies a negative market reaction in Korea, which is inconsistent with the results for the US market due to the unique timing of announcements, as the watchlist tends to be issued simultaneously with rating changes. This study makes three contributions to the literature. First, it is the first study to document the watchlist in the Korean credit rating market. Most studies have examined market reactions with respect to rating changes. The findings will be useful for academics and practitioners. Second, the study comprehensively investigates the role of the watchlist in Korea and discloses the genuine economic function of the delivery of information. Finally, the paper suggests policy implications for encouraging more issuance of speculative grades, separation from grade changes, and periodic evaluations.
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