Cross Sectional Variation of the Effect of Bond Rating Changes on Stock Prices

• Main Authors: GOH, Jeremy C., EDERINGTON, Louis H.
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 1999
• Subjects: Business; Corporate Finance; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/1271; https://ink.library.smu.edu.sg/context/lkcsb_research/article/2270/viewcontent/Cross_Sectional_Variation_1999_pv.pdf
• Institution: Singapore Management University

Previous research has found that the stock market reacts negatively to bond rating downgrades and that downgrades tend to follow periods of negative returns, indicating that at least some downgrades are partially predictable. Hypothesizing that the reaction to a downgrade depends on both the implications for cash flows and the degree of surprise, we explore how the reaction to downgrade announcements varies across bond issues. We find that the equity market reacts much more negatively to bond rating downgrades to and within the speculative bond category than to downgrades within the investment grade category. Within the speculative category, the reaction is stronger, the lower the old and new ratings are. The reaction to multiple-level downgrades is not very different from that to single-level downgrades. The market reaction is also stronger if the firm has experienced negative pre-downgrade abnormal returns. Our evidence indicates that downgrades are viewed by the market as providing information on likely future earnings before interest charges, not just likely future interest charges. It is also consistent with Billett's (1996) hypothesis that low rated debt makes a firm less attractive as a takeover target.