Information content in CDS spreads for equity returns

•We explore the predictability of equity returns using information from credit protection returns.•Equity returns can predict credit protection returns up to 5 days, especially for non-investment firms in turmoil market.•Credit protection returns are more sensitive to lagged equity returns if credit deteriorates in CDS market previously.•One-day-ahead equity returns significantly respond to credit protection returns around the credit rating announcement.•Market is over-reactive to the potential positive credit rating announcement.

This study focuses on the information spillover between the credit protection returns and equity returns for 252 United States firms between 2004 and 2010. There is significant information flow from the equity market to the credit default swap (CDS) market under turmoil conditions for investment-grade firms and the reverse is true for non-investment-grade firms. There is also strong evidence of extra information contained in the positive credit protection return one day for the equity market the following day. The behaviour of the markets around credit announcement day leads us to believe that there may be informed trading in the CDS market for high-credit-rating firms.