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Journal of Banking & Finance
journal homepage: www.elsevier.com/locate/jbf
The impact of bond rating changes on corporate bond prices: New evidence from the over-the-counter market Anthony D. May *
Price College of Business, University of Oklahoma, 307 West Brooks, Norman, OK 73019, USA
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I study the information content of bond ratings changes using daily corporate bond data from TRACE. Abnormal bond returns over a two-day event window that includes the downgrade (upgrade) are negative (positive) and statistically signiﬁcant, although the reaction to upgrades is economically small. Monthly abnormal bond returns around downgrades and upgrades are statistically signiﬁcant but overstate the magnitude of the reaction relative to two-day abnormal returns. Unlike the bond market, the stock market reaction to upgrades is statistically insigniﬁcant. Evidence suggests that the differing inferences on the effect of upgrades in the two markets can be attributed to wealth transfer effects rather than relative market inefﬁciencies. In the cross-section, the bond market response is stronger for rating changes that appear more surprising, rating changes of lower rated ﬁrms, and upgrades that move the ﬁrm from speculative grade to investment grade. Ó 2010 Elsevier B.V. All rights reserved.
Article history: Received 29 August 2009 Accepted 10 June 2010 Available online 15 June 2010 JEL classiﬁcation: G10 G14 G24 Keywords: Corporate bonds Bond prices Bond rating changes
‘‘The story of the credit-rating agencies is a story of colossal failure.” – Rep. Henry Waxman (California), Chairman of the House Committee. Wall Street Journal, October 23, 2008. ‘‘I never have bought any bonds over the last 28 years based upon the credit-agency ratings – they are always delayed on the upside or downside.” – Leslie Beck, certiﬁed Financial Planner, Cupertino, California. Wall Street Journal, November 2, 2008.
1. Introduction The statements above represent how many lawmakers and securities professionals view the major bond rating agencies. High proﬁle bankruptcies of highly rated ﬁrms, such as Enron in 2001 and Lehman Brothers in 2008,1 have led many to question the value of bond ratings. Rating agencies claim that their bond ratings partially reﬂect private information, and hence the information content of bond rating changes is a topic that has received considerable
attention in the academic literature. Numerous studies ﬁnd that the stock market reacts negatively and signiﬁcantly to bond rating downgrades. With the exception of a few recent studies, most fail to ﬁnd a signiﬁcant stock market reaction to upgrades.2 A handful of studies have focused on the bond market reaction and produced mixed evidence. Consequently, whether and to what extent rating changes bring new information to ﬁnancial markets, especially bond markets, is a question unresolved by the literature. Using monthly corporate bond returns, Weinstein (1977) and Wansley and Clauretie (1985) do not ﬁnd signiﬁcant reactions to downgrades or upgrades in the month of and month following a rating change. In contrast, Grier and Katz (1976) ﬁnd that industrial bonds react negatively in the months following a downgrade, while Hite and Warga (1997), using monthly dealer quotes, ﬁnd signiﬁcant bond market responses to both downgrades and upgrades.3 Using daily bond price data from the NYSE, Hand et al. 2 Grifﬁn and Sanvicente (1982), Holthausen and Leftwich (1986), Wansley and Clauretie (1985), Cornell et al. (1989), Hand et al. (1992), Goh and Ederington (1993,1999), Ederington and Goh (1998), Norden and Weber (2004), Li et al. (2006), and Kim and Nabar (2007) ﬁnd signiﬁcant stock price reactions to downgrades but not to upgrades. Dichev and Piotroski (2001), Jorion et al. (2005), and Jorion and Zhang (2007) ﬁnd statistically signiﬁcant stock...