Downgrade Alpha

S&P Capital IQ’s recent research demonstrates a strong link exists between credit events and equity returns.

We empirically examined the equity price responses to changes in the opinions of Standard & Poor’s Ratings Services’ (S&P Ratings Services) credit analysts within the Russell 3000 universe from 12/31/1999 – 12/31/2013. We found the strongest negative returns occurred to downgraded companies in three scenarios: high yield companies, multiple notch movements, and highly leveraged companies.

Why look to ratings?

S&P Ratings Services credit ratings express an opinion about the ability and willingness of an issuer, such as a corporation, state or city government, to meet its financial obligations in accordance with the terms of those obligations. S&P Ratings Services analysts’ views are significant as they engage top management to obtain additional information and insight about the issuer’s current position and future plans. In other words, ratings take into account not only the present situation but also the potential impact of future events on credit risk.


Below shows the average equity returns 20 days after a downgrade. These returns are conditioned for the common risk factors of value, market, and size. Figure 1 displays a marked difference in the performance of Long-Term Ratings changes between speculative and investment grade rated companies.  Downgrades to speculative grade issuers generated cumulative back-tested average abnormal return (CAAR) of -275 bps and underperformed the market 59% (hit rate: 100% - 41%) of the time compared to investment grade issuers which generated -112 bps and only underperformed 53% of the time. Figure 2 shows large downgrades generated abnormal back-tested returns of -294 bps the 20 days following a Long-Term Ratings change while a small downgrade yielded -158 bps. Large downgrade performance is slightly more consistent as underperformance occurred 4% more frequently (hit rate: 41% vs. 45%) than small downgrades. Large downgrades constitute any single rating change that is more than 1 notch. Lastly, in figure 3 we observe downgrades to leveraged firms generated a CAAR of -318 bps and underperformed 58% of the time compared to underperformance of -59 bps and 55% for less leveraged firms.  We classify companies with debt to equity ratios greater than 1 as highly leveraged.  

Event Study: Long-Term Rating Changes

12/31/1999-12/31/2013, Fama-French Adjusted Back-tested Returns

Source: S&P Capital IQ Quantamental Research. For all the above charts, backtested returns do not represent the results of actual trading and were constructed with the benefit of hindsight. Returns do not include payment of any sales charges or fees. Inclusion of fees and expenses would lower performance.  Past performance is not a guarantee of future results.

***, **, and * denote statistical significance at the 1%, 5%, and 10% levels respectively


Why These Types of Companies?

High Yield companies are typically more cyclical and have a higher correlation to equity markets. Secondly, multiple notch downgrades may be more significant because they represent a more pronounced change in the credit analyst’s opinion of the underlying business and financial risk. Lastly downgrades to highly leveraged companies may have a stronger effect due to higher cost of capital to finance the company’s debt potentially leading to decreased profits to shareholders.

View the full research paper here.

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