The Rating Implications of Consecutive Earnings Increases and Decreases

Abstract

Abstract

Literature on meeting or beating earnings thresholds is well developed in equity markets but is limited in debt markets. I extend this strand of research by investigating the economic implications of strings of earnings increases and decreases for credit ratings. First, I examine whether a rating upgrade (downgrade) proxied by a change in credit ratings is associated with a string of increasing (decreasing) earnings. Second, I investigate whether predicted future earnings uncertainty and firm fundamentals provide incremental explanatory power for credit rating changes. I document that a string of increasing (decreasing) earnings is associated with higher probability of a credit rating upgrade (downgrade). This holds even after controlling for predicted future earnings variability and fundamentals. I also show that both predicted future earnings variability and fundamentals have incremental explanatory power. In addition, the robustness tests show that credit rating surprises measured by differences between actual and expected credit ratings are influenced by strings of earnings. The collective results provide an insight into how earnings strings play the roles in debt markets.