The credit risk–return puzzle: Impact of credit rating announcements in Australia and Japan

•The study analyses the credit risk–return puzzle in Australia and Japan.•The test is undertaken across various economic states.•It seems that the credit risk–return puzzle exists in both Japan and Australia.•We confirm that Australia's experience in the crisis is different.•The credit risk–return anomaly is explained by the rating downgrades.

Traditional asset pricing models postulate that high risk investments are usually associated with higher returns. However, this does not hold in the relationship between credit risk and return. There is a known credit risk–return puzzle, which highlights a negative relationship between credit risk and the stock market returns. The objective of this study is to assess the puzzling credit risk–return relationship of stocks; in particular, comparing the stock returns of high versus low credit risk firms, as measured by credit ratings from Standard and Poor's in Australia and Japan for a period from January 1990 to June 2012. Our results indicate that the credit risk–return puzzle exists in both Japan and Australia. However, it seems that the credit risk–return anomaly is explained by the downgrade announcements in the market and hence we conclude that downgrade announcements of a firm have a significant impact on the cross section of returns.