Executive summary
The efficient market hypothesis asserts that markets are efficient and that stock prices accurately reflect all available information. Theoretically, the posit can echo in bond markets as well.
By extension, these market signals, particularly, significant movements in the prices of shares and yields on bonds should mirror market perspectives on credit profiles as well.
To be sure, numerous quantitative models exist that assess the creditworthiness of an entity by incorporating market-based inputs into their analyses.
For example, models such as ‘distance to default’ utilise historical defaults and market capitalisation of entities to predict future defaults. Another is the Altman Z-Score, which predicts bankruptcy probabilities based on inputs such as the market value of equity.
But not all market movements are linked to changes in credit risk profiles. There are other factors at play as well, which can impact the dynamics of that.
Share price fluctuation, for instance, can be influenced by overall market sentiment, expectations, demand-supply, liquidity, and momentum. These may not necessarily align with an underlying company's credit quality.
Furthermore, the stock market tends to prioritise metrics such as earnings per share and potential upside. If such expectations are not met, there can be a correction in share prices.
In contrast, credit ratings focus primarily on the fundamental strength of a company, in terms of its business operations and financial stability, and ability to withstand shocks.
Similarly, in bonds, factors such as market liquidity or illiquidity, sector-specific concerns, and macroeconomic environment can have a bearing on sentiment and, consequently, yields. But these factors may not potentially impact the creditworthiness of the underlying entity.
Sentiment can also occasionally drive changes in share prices and bond yields that are challenging to rationalise. Warren Buffett summed it up cogently: “When the price of a stock can be influenced by a 'herd' on Wall Street, with prices set by the most emotional, greedy, or depressed individuals, it becomes difficult to argue that the market always prices assets rationally. In fact, market prices often defy logical explanation.1”
On their part, credit rating agencies (CRAs) factor some of these signals to supplement fundamental analysis.
But it is crucial to distinguish between credit and non-credit factors that lead to the generation of market signals.
To assess the reliability and effectiveness of market signals (such as share prices and bond yields) in predicting changes in credit ratings, CRISIL Ratings conducted a study on its rated portfolio.
The purpose was to decipher the linkage between market signals and changes in credit rating, to evaluate the extent to which the signals align with a CRA’s assessment of creditworthiness.
The study provides valuable insights into the relationship between market movements and credit ratings.
The results of the study are covered in this article.
