We examine the pricing relevance of credit rating downgrades when the underlying firm has Credit Default Swap (CDS) contracts trading on its debt. Using a comprehensive sample of credit rating changes from 1998 to 2007, we find that, after a CDS contract starts trading on a firm’s debt, the firm’s stock reacts significantly less to a credit rating downgrade. Firms with traded CDS also have a smaller stock and bond market reaction to a credit rating downgrade than firms without a traded CDS. In addition, CDS spreads explain the cross-sectional variation in primary and secondary bond yields better than credit ratings. One important implication of our study is that it may be beneficial for regulators to focus on improving the transparency in the CDS market rather than solely addressing the conflicts of interest inherent in the business models for rating agencies.
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