Cross-sectional variation in the stock market reaction to bond rating changes

The Quarterly Review of Economics and Finance, Vol. 39, No. 1, 1999, pages 101-112 Copyright © 1999 Trustees of the University of Illinois All fights of reproduction in any form reserved ISSN 1062-9769

Cross-Sectional Variation in the Stock Market Reaction to Bond Rating Changes

JEREMY C. GOH Drexel Uuiversitv

LOUIS H. EDERINGTON Ullivcrsity of ()klahoiua

PreT,i.u.s re,earth ha.~ fi,and th.t the qock mark,'t reacts n~:~.'.tively t. boml rating d.w.~.~rades aml that don'n[;rmle.~ tend to [bll, m, I,erio¢l.~ o[ .egative relar..~, i.dicatlng that al h.a.,t .~ome dowiigrades are partially predictable. Ilyp.the~i:in g that the rr'a(llolt to a ¢hm,.Krade cb'pe.d~ on both the implicat,m.~ /or ca.~h firm's atul the deg.re¢ cd' sarpri.se, il,e explore h.w the reaction to downl.~'mle anmatncemrnt,~ varie.~ rcros,s bond ix~ue.~, II'e ]i.d that the equity market reacl.~ ranch tm.e negatively I. h . . d rating d.wnl;rmh'.~ t. aml within the .~pec.hdive b,md category tha. to thm,.I;rarh'~ within the inve.~tmenl Krade c~d,'gmy. II'ithm the ~pectdative categmy, the reaction i.~ .qro.ger, the lower the ohl ttml .ew rati.ffs are. The reaction to maltiple-h'vel downl4rade~ i.~ md t,ery di]]bre.t ]r.m that t. .si.gh'-h,vel dawng.rade.~, The mmket reaction i~ al.~o .~tr..ger i] the firm has experiemed negative pre-downKrade ahm.'mal retarn.~. Oar evidrm'e imlicate.~ that dow,,grad,,.~ a , e view,'d by the ma,'k,.t a.~ p,',,vidmg i,tfi,,',nati,,n ,,n likely ]ulure earuings befi,,'e intere.~t chai~e.~, n.t ja.~t likely Jut.re intere.~t cha~x.e.s. It is al.~o c.n.~i.ffent with Bdlett~ (1996) hyp.the.~is that fire, rated debt makes a firm le.~.~attrattive a.~ a takeover tmget.

Numerous stvdics have clocumcntcd that cqvity prices react ncgmivcly to announccnlcnls of bond rating downgrades (Hohhauscn and I.cftwich, 1986; Hand, H
!01

102

QUARTERLY REVIEW OF ECONOMICS A N D FINANCE

(1993) have shown that the stock market only reacts ncgadvcly to downgrades which the rating agt'ncy attributes to a dctcrioratiot~ in some measure of the firm's fitmncial ProsPects. such as Carnin~. cash thaw. or sales - that is down-

grades ~dlere stockholder and b o n d h o l d e r interests ;+tt+e aligned. T h e y lind no re,tctiothcsizc th;tt thc ma,kct rca<:ti<>ll dcl>Cnds on tw<~ l'actwngradc is a stUl+rist_'. ()bviuld react truly to surf>rise dc>wtlgradt',+ ml<[ several SttLdit_'s (llohhattst'll atld t,cliwich. 1986; Wanslcv and (;latnrctic. 1985; Matoksv a,ld l,iat,to. 199-0 liqd th,tt dlyiIlg that at lt'ast so,no downgr;tdcs arc prcdict,tblc. Scc~mCtld ort.mcc oI" the itdi>rmati<+,L given that it is a st,ilwisc, l~,<~th o f these suggcst that the m,trkct rt'acti~m will dill'or across firms at~cl l>rc strm hv¢cnttt+cttt to Sl)Cctnlativc gradt, th,tn~ to downgr.td<:s in gcncr,d, lhm'evcr, our cviOrtmtt; the reztCti.t~ u, downgr,,Ics withi, the spt'ctdativc catcg<~ T (l>,u'tictdarly Io I~, and (',;m) is cv<+'t~stronger. ()ur evidence is consistct~t with Bilh:tt's (1996) hyl><>thcsis th,tt low rated debt h~wcrs the likelihood o f a take'over. Wc also lind tlmt the lll;trkt'l reacli<~ll is stronger if" the firm experienced negative al>ntlt" evidence indicates that the reaction is not very dillL'rent if the d<>wngradc is only one rating Icvcl, e.g., Aal to Aa2 or A,t3 to A I, or more than one rating h_'vcl (e.g., Aal to Aa3). ()ur rcsttlts tend to SUl>l)Ort the view that the downgrade provides inlbrmation regarding bcfi>rc-itHcrcst, ,ts well as alJcr-intcrcst, carni,+gs. T h e rein:tinder oF this iml>Cr is ;trrangcd as Iws. In Section 1 we describe ottr d+.tl;.t ,lied present basic I'CStdts. I~+ Sccti
STOCK MARKET REACTION TO BOND RATING CHANGES

I.

103

DATA.

For this analysis, we collected data on all c o r p o r a t e b o n d rating changes bv Moodv's between J;.IIILKII) I. 1984 a u d D e c e m b e r 31. 1 9 9 0 - - a total of 1526 of which 104:+ were downgrades and 483 were upgrades. In o r d e r to locus grades. :; l)escril>tive statlislics are rei>ortcd in Talflcs 1 amd 2. In "I'able 1, wc rcp<>rt distriln,tiy y<.'ar and l)v the magtfitt,(le
T.hI,, 1. D e s c r i p t i v e S t a t i s t i c s "l'hc Saml>h: tousisls oI" M~uulv's rathlg <.hangcs I<38-I-1990 alh'r climil l + t l l l l ~ l l l l l l S with a l l ; l l l l l O t l l l C t ' l l l ( + ' l l l ill the illlll(Rlllt'L'llll+'lll Willd(W,,' hcsidt,, the rating change and lhnls withoul p,'icc data on CR.~P. The li,t;mcial p,'OnlmCtS ,,t,l>satnlflt" conni,+ls <>I thost" i';.|titlg dlal+gt"+ wl,ich ,M~+odv,, itttril,,tvs to it change in the li,'n,'s li,~a,,wi;d l,..,l,:Cts. FulL Sample A.

Year

Financial I'rospects Sample

Downgrades

Upgrades

Downgrades

Upgrades

52 69

I; I

29

32

I ~.)s5

5-I

48

43

19Sll 19,"+7

Sl 6t

-13

."J~

36

tI

42

I t)~ 1t.)~t.)

-d+)

44

-I I

'2()

t+,5 3~

27 30

I 17

-19

.12

26

19~-t

19c.1() B.

I ,~

Distribution of Ratings Grade Changes

I ( ,l';l(IC 2 (;radcs :~ ()1" Illl)l+t'

279 I I~

201 ,~+)

I-tli ~7

157 67

311

I<.)

~',+q

8

P,a2 Ba3

N G

( kvl

B3

B2

B

P,a I

.'~12 .-\a3 A1 :\2 A3 Baa I Baa2 Baa3

1

R A T

0 L D

Aa I

.-~m

7hble 2.

Old

S 1

o-

Aal

Aaa

6

New

and

10 o

3

3

Aa2

Ratings

12 3

"4

o

Aa3 l

19 6

51 6

'2

AI

18 5 1

6 12

A2

14 1-t

')25

A3

1

15 5

8 14

Baal

1

9

16

3 8 7

Baa2

NEW RATING

1

4 1

11

3 7 21

Baa3

1

5 5

1 4 8

Bal

3

8

4

I 1 8

Ba2

1

14

4

6

5

1 '2 4

Ba3

'2

6

6 5

3

'2

BI

-t

6

-t l'i

B2

I I

I

17

I~

B3

7

7

I

1

Caa

~" M

"~ Z

O Z O

O

t~

M

"~

M

STOCK MARKET REACTION TO BOND RATING CHANGES

105

ing including the number modifiers, e.g.. from ,~!2 to .~!3 or from ,~a3 to A i . In Table 2. we report the rating changes for the full sample in a matrix fi)rmat showing the old and new rating categories. Our rating change anqouncement dates (day 0) are those listed in Moodys Bond Sun,,~' (MBS). Some, but not all. of these rating changes are reported in t h e Wall Street Journal; if they are, it is ahnost always the day following that.listed in MBS so our a n n o u n c e m e n t window consists of days 0 and + 1. Since both o u r d a t a and previous studies indicate that downbq'ades tend to occur after other bad news and when the firm's stock has been doing poorly, we use a post-ratingchange period (day +60 through +315) to estimate a market tuodel fin" each tirm. T h e market models are estimated using CRSP close-to-close return data and an equally weighted market index. Abnornml returns are delined in the usual matuler by subtracting the e x p e c t e d return implied by the estimated market model fi'om the daily return fi)r that firm. Mean cumulative abnormal returns, CAR, are r e p o r t e d in Table 3 for both upgrades and downgrades and Sel)arately fi)r our sub-samt)le of those rating changes which Mo<)dvs attril)utcd to a changed evaluation of the firm's linancial prospects. Consistent with earlier studies, we tirol a signiticant negative reaction to downgrades hut little reaction to ul~grades. For the Ihll downgrade sample, the mean two-day a m , n m c e m e n t period CAR is -1.2 l e~, with a t value o f - 6 . 1 8 . For the sample of downgrades atlriln|ted by Moodys to a change in the firm's lin,mcial prospects, the rueart two-day ('AR i s - I . 5 1 % with t = -5.49, Furthermore, (;().59~ o f the 266 dow,lgn',lde two-day almormal I'eturnls are n e g a t i v e ~ a proportion which is signilicantly dill'trent from ,5()t/t; at tile .01 level, l.ike prey|otis sttLdics, we ohserve no signilicant xmu'kct I'CilCtioII tO ul~gratles. C()nsistent with ! h)hh,ulscn ancI l.eftwich (1986), we ohsex've significant negative ,flmormal returns l)rior t() d()wngrades and signilicant positive aline)final returns prior t() ut)grades. ! F()r the limmcial-i)rosl)eCts-d()wngra(lc sul)-sample, the mean CAR over days -45 through -1 is -5.15% with t = --1.35. For ul)grades, it is 3.02~)~ with t = 3.87. T h e s e resuhs imply that downgrades (ul)gradcs) are partially predictal)le in that they tend to occur tbllc)wing periods of bad (good) news and/or Ol)erating resuhs.

7hble 3.

Mean Cumulative

Abnormal

Returns

Full Sample Period

Days 0 and 1

Downgrades

-1.2 I'U/~ (-6. I ,~5)**

l)av~

--15to

-I

..l.,~-lg"Jt

(-5.57(1)*" Nol¢:

Financial Prospects Sample

Upgrades

Downgrades

Upgrades

-1.5 IO"A

-0.17.V)I

(0.(i3)

(-5.-19)**

(- I. 19)

3.806".k (-t.81)**

-5. l-lSt,:i (--I.35)**

.()gY/~

I-'~I;llt'~lit% ILI'L'~,llo',Vlt ill pilR'l|IIIt'%{'%. ( }!l|t' illlll I'o,O aslcri,,k,, dt'~,igtl;t|c ishtlq~l'ltl;|l ;Ir~' s i g m l l c ; m l l y d i l l i . | c | | | li.tm| tcrt~ at II~c .05 a n d .01 le',cls uC',lwtii,,cl','.

3.0219~, (3.,'47)** tl*lUl'll% w h i c h

106

QUARTERLY REVIEW OF ECONOMICS AND FINANCE

-l',tken t o g e t h e r OLll + p l c - ~ + t l l n ( ) t l l i c e i i l e n t t l l l d ~.llll11)LlllCenlqnt window FCSLIItS indicate th,lt downgr+idcs are parti,tlly duc t() p r i o r nt:gative public inlorlt'~ation which both the rating +agencies ;+ttld stockholders h+l~c ah'cadv received but th,lt n o n e t h e l e s s stock milrket p++n'ticipitnts view d o w n g r a d e s as p r o v i d i n g some new ilfform,ttion. In contrast, upgradc.s a p p e a r to be solely due tt~ pttblic infortnation.

II. T H E C R O S S - S E C T I O N A L TO DOWNGRADES

VARIATION

IN THE MARKET RESPONSE

Attention is now turnc'd to how the nutrkct reaction t() a rating c h a n g e varies across ratings and bonds. Since we observe no market reactirise, and (2) the intrinsic i m p e l t a h o e o f the inlbl'm,ttil)sclved for alm<,st 4()r/+ <>f out +siltnl)le. A.

Pre-Announeement

R e t u r n s anti the S i z e o f the D o w n g r a d e

l ' h e tact tlmt most d<~wllgrad<:s arc I>rccc(Icd I)v ncgativc' ,d)n~wm,ll voter,is I'lliSL'S lilt, (lllusli(+ll <>f II(~w lilt' Illill'kt.~l I"t'H('li<)ll I() the." (l()Wllgl'~,tdC illlll()llll(.'L'llICIIt is 1"(21~llt¢(I I() Iht._'n¢' I)l't'-(l()wllgl',l(le ICltllll.'.;. ] [(jWCV¢.'I', IhCSe I)l'q-.Slllll()lllICelllelll retnrns ¢f the' (h~wngra(le and Ihe two lead to dill"crenl l>re(licliw returns. All <)lhcr lhitlgs equal, the tn,lrk('t sh(~l,hl only rcact t+~ surl)rise dxlgly negative. Ihell it seems likely that Ihc tblh+wing (h+wngra(Ic will t)t: largely a,lticil);ttt:(I. If s~. tile reaction t(> tile ann<>uncenlent sllrise and enge,ldet" a larger a(ljustment. T h e itnl)lication (>I"this "surl)risc" hyl)<~thcsis is tllat l)rcannoullce Inctlt and ann(~tmcenlellt peri<>d returns should be negatively correlated. ()n tile <>tiler h;ind, l ) r e - d o w n g r a d e returns ++'ill tend to be greater, ill ;Ibs<+lute terms, the hu'ger the e x p e c t e d impact o f the d o w n g r a d e , implying a positive cse now that negative pt,l>lic intbrmati(>n is received which causes negative returns a,ld raises tile in:tl'kct's estitnatc o f the likelih<~o<~sc that b<~lh arc sul~scwngraded I>ut that ill X's case tile

STOCK MARKET REACTION TO BOND RATING CHANGES

L07

d o w n g r a d e is viewed as i m p o r t a n t for stockholders while for Y it is viewed as relatively inconsequential. -I'his conld be because, it) the case ¢)[ X, the d<>wngrade is viewed as due to [actors import:rot t<) stockholders, such its e x p e c t e d futttre profits, while, in Y's case the d o w n g r a d e is viewed its due to factors i m p o r t a n t to bondh()lders only. If" this is the situation, then fi)r firm X, both p r e - a n n o u n c e merit and a n n o u n c e n m n t period returns will be large and negative while for Y both will be small. We label tiffs hypothesized positive correlatiort between a t m o u t l c e m e n t period a n d p r e - a t m o u n c e m e n t returns the " i m p o r t a n c e " hypothesis. T o test these hypotheses, we regress the two-day anrtout'tcement period CAR on the 45-day p r e - a n n o u t l c e n m n t CAR. CAR(-45.-i). T h e "surprise" hypothesis implies a negative coef'l]cient for (;AR(-45.- 1), while the "importatlce" hypothesis implies a positive coefficient. We als() relate the reacti(m to the dowtlgra([c atmouncetuent to (l) the ntmlbcr of grades the rating is reduced, and (2) a duntiuv for the recession ye,u" 1990. Sitice, it d o w n g r a d e ['1'o111 Aal to AI should signal WOl'Se news than a d o w n g r a d e fi'otn Aal to Aa2, we d e t h m N U M _ ( ; R D as the nunlber o[" gv,t([es (based o n t h e i n < i ( l i l i c d o r r e t h l e d r a t i i l g s ) t h a t t h e r a t i n g is r e ( h l c e d . F o r cx~iilipie, N U M _ ( ; R I ) = 1 ['fir a c h a n g e t'i-<)iii : \ , i l to A a 2 w l l i l e N U M _ ( ; R I ) -- 3 |()r a c h , l i l g t ' ti'olli A , i l Io A I . 5 F i l i a l l ) , siiice d t l l ' i n g a rt'ccssioil iliVeSl
Tahh' -I.

R e g r e s s i o n o f the M a r k e t R e a c t i o n to a D o w n g r a d e on Bond and Rating Characteristics "lhc d c P c m h ' n t

v;u'iahlc is th(: two-d~w iltintHlti('t.'lllt'tll

Period

(::%R. NUM_(;I,P,I) is lilt' IIIIlIII)CI'(t,l' gl'a(It:s (relined ratings) Ill+at the ratiug is vcducc(l. (:AR(-.15,-I) is the CAR ovt..v the pcriod from day --15 (relative to the ;llllltltillt'clnclit) thr
sh(m'n izl l)aVctlthcm_'s. Variable [nterCt.l~t CAR(--15,- I )

NU M ( ; Rl )

Regression l

-I}.0056

(-1.4-0

(-0.89)

.0591)

.0552

(4.21 )**

(3.97)**

.0<)O:L"+,

(0.12) -.02.12

l) 1990

(-:L31)) *° ."+I'EC

(;RI)

FAL.I.EN

Regression 2

-O.00~

.0027

(0.7~) -.1}2-13 (-3.35)** -.0151

(-2.1;[+1)** -.1)170 (-1.91)

108 QUARTERLY REVIEW OF ECONOMICS AND FINANCE

concerned about the risk of detault, we inchlde a dunmly, D1990, for the recession vear 1990. Results of this regression are shown ill tile first cohunn in Table 4. Confirming the "importance" hypothesis, the coefficient o1" CAR(-45,-I) is positive and significant (t=4.21). T h e implicati(m is that the reaction to the a n n o u n c e m e n t is greater if the firm has ah'eady been experiencing negative abnormal returns. Instead of indicating that the subsequent downgrade is largely anticipated, large negative pre-downgrade returns seem to indicate these are the downgrades of most concern to the market. T h e 1990 d u m m y is also significant. However, the coefficient of NUM_GRD is small and insigniticant, and (surprisingly) even has a positive sign. T h e implication is that the market reaction is roughly the same whether the rating is reduced only slightly, say fi'om Aa2 to Aa3 or several grades, say front Aa2 to A2. B.

Differences by Rating Level

Another issue is how tile nl,ukt't reaction to a downgrade a n n o u n c e m e n t del)cnds Oil tile rating level. As noted abtlve, l iolthausen and Leftwich (1986) find evidence that (Iowngr,l(les which ill()Ve tht' h()nrl I'ronl invcstlnent to sl)cculativc stattls gt'iicr, lle I:u'ger illiit'kt't re:lctiotlS than d(m'ngl'ades in genel',ll. In their contanfinated s,unl)le, It,ind, i[olthauscn, and l.el'twich (1992)tin'thor obsel've that downgi'adcs ,unong spccltl,ttive level bonds gencr:tte a larger equity t'eactioll tit:in do dowtlgr;.ldcs antoiig bonds r:ltcd :it tile investinent grade level hut thel'e is little di[]'~rcnce ill thcir titlcontinniliated sanlple. "l'here are several t'casotls ll} expect tile ln:ll'ket reaction to (h)wllgra(le atlnollncenlc'nls to dillk:t" between lower alid higher" rated honds. Again. these t'elate to: (I) whether el" II~.lt the ¢ll" lower rated issues, l.'or illstancc, the yield spread between issues t'atcd i{,l ;.tild 1~, in greater than lit,it hetween issltes r:tte(I Aa and A. 11"thel'el{>l'e both ch;ltlges are equally sut'l)i'ising, a I:lt'ger illct'ease ill the lii'in's filtUl'e interesl costs in inllilied in the case of downgrades ailiOllg lower rated boil¢is, which inllllies that the nlarket rt.,aclion to tile downgrade should he gi'eatel" fi)r lower rated lit'Ins. Second, it in possible that high rated lit'ins are bhle chip []i'nls which genel'ale inoi'c news alld are nlol'e ch~sely I7~llowed than low raled lit'ins. Consequeiltl)', downgi':ides nt,lv lie stirl)ri,dilg I(>i" low rated firms while the downgrades of high rated lit'ins arc Ioirgel)' anticillated. This wotild inllll )' thai ill tile case of high rated issties, we should ohst_'l'vc negIitive returns lli'ior Io downgi',ides but little reactiOil to tile downgi'adc, itself. For low i'aled issues, we should expect

STOCK

MARKET

REACTION

TO BOND

RATING

CtU~NGES

109

small pre-downbq-ade returns and a large negative reaction to the announcement, Finally, a larger market reaction to d()wngrades to speculative grade levels m a y be obsetwed because they make the firm less attractive as a takeover candidate. Billett (1996) t]rtds that, ceteris paribus, firms with large amounts o[" speculative debt otttstanditig are less likely to he a taket)ver target than equix'alent f i r l l l S with investment grade debt. He reasons that []rills with low-rated debt itl'e less attr,tctive since, if the acquiring tirm has higher rated debt than the acquired firm, then the acquisition results in a wealth transfer fi'om the acquiring firm's stockholders to the acquired firm's bondholders. This hypothesis implies larger reactions to downgrades to and a m o n g speculative level firms but little difference in p r e - a n n o n n c e m e n t returns. In Table 5, we report mean CARs fi)r three downgrade subgroups within the financial prospects sample: (I) downgrades within the investment grade categt)ries (Aaa through Baa). (2) downgrades within the speculative or j u n k bond categories (Ba thr()ngh Caa), anti (3) downgrades from htvestmettt to speculative grade - the st) called "fallen angels". While significant ;it,the .0l level, the illeall a n n o t m c e m e n t l)eriod CAR for downgrades within the investment gr,tde categOP," iS s m a l l , - . 7 5 ~ . T h e i n a r k e t i l l ) l ) ; i r e t l t l y d()es n o t r e g a r d lllese d o w l l g r a ( l e s its l)artictllilrl,v illfi)rlllalive I'()r st()ckhol(lt:rs. For itlvc'slmcnt gra(le I)t)nds, tile |)rt2-;.tnllOtlllCt2lliellt l)eri()d CAR is also relatively small, -2.79q,,

7hble 5.

Cumulative Abnormal Returns and Rating Categories

M e i l l t (.:tltlllllilliVt' i l l l l l O r l l l i l l I'ldttlrllS ()vl.'r I h t ' ;IIIII()IIIICCIIIL'III p l . ' l i O d ( d i l y s () i l l l d

[)

a,l(I I)rcannounccmcnl pcri()(In ((lays --15 thr(mgh -I) arc rcportcd I)y raliug level. The Saml)lc c()nsists ()f '2lili (h)wngra(lcs ovcr tlt(: l)Criod 19,~,I-L9(,)0 attrihutc(l hy M()c)dv's t() changcd Iinanci;d i)r()spccts. ()tic anti two asterisks (lent)to means which ill't_"signiticantl,v (lilfi:rcnt t'l'Olli Zt3I'<) lit the .(15 alld .OI levels rcsl)CCtivcly. Announcement Period Rating level

Within investment grades Within Sl)cculative

Mean CAR

t-statlstlc

Pre-announcement Period Mean CAR

t-statistlc

Number

-.730t';

-2.~')-l*

-'2.793'/r

-'-LOS*

I-It

-2.-1()6g

--l. 17**

-7.62'~/~

-3.09**

90

Fr()lll illVt°silllt'lll Ill --2,+11)~¢){ s p e c u l a t i v e gra(lcs To and within rating level:

--2,~)**

-~.78~+,~

--~.(; I **

:{2

&t

-.:),-I 2':I

-.5-t

13

- 1.0S(.lCi

-.(iO -2.00"

- 1.7-I I '7,,

A

-2.719',;I

- I .,15

B;,a

-.338',~,

- 1.-16

-3.(;8(i';;.

- 1.73

l));l I). ( :aa

- 1.713~:~ -2.21i-I' ~' --I .8(;7~/*

60 7I -I'I (;2 I (i

gra(It's

-'2.30" -:)).(J 3 " * -2.28*

--).8(;( )','{ -:').970C{ - 2 1 . 2 ( ).l t:~

-'2.(;(;* * - 1.0-I - 3 . 0 1* *

I I0

QUARTERLY REVIEW OF ECONOMICS AND FINANCE

Both the HIII|()UIICelII(*II[ pCl'i()([ HII(i pI'¢.'-~I.II[IOUIICe[IlCII[ (+~,-~Rs |'O1" lilt.." o[hc[+ two gr<,ups ave much Idrger. For d<,wngradcs within the spect, laLtivc categ~.,t'y and tor f, tllcn angels, the announcement pct'iod CARs are both -~.4l~. Obviously, these att'e downgrades which stockholders view as having fairly strong negative implications. On the other hand. our evidence indicates th,tt these ant,out,cetnents do not come out of the blue ;rod should not be a complete surprise since the pre-amnOunccmetlt period CARs are -7.6.'2r~ and -8.79~fi respectively. While we Cam rc~je<-'t the second of the three h,vpotheses outlined above fiw the differential response to d<~wn+zr:tdes of low-rated debt, the difl~:renti,tl news hypothesis, our results are consistent with both the first and third of the hypotheses outlined above, i.e., the reuc'tion is strwcn" the new rating.' ,-\lthotlgh the iHiitll~<-'r ol +bccially strong: -1.,"17+~. ,&l~lmn'cnll+v. t>~,ld d~mngn',lankrtll>lC.V <~t"dcl~itflt ,Ire +.icwcd by the stc,<.k utn;trkct as l>arlictul:u'l+v hfl'<~n'xllatix'c. :\ct'~ss the six I',tlitl~ h..vcls, i>rt:-~illll()tttlt_t'lt+clnt p<-'ri<+d CAl,ts ~tt'e <-onsistelltly lm'g~.',' (itt abscri<~ds when the IIl'nl's st<>ck It;is i)erftnncen~et|t i>cri~cl rca<.tion~ is still sti'<,x~,g. "l'ogcthcr the antH>tH~ccnncnl p e r i o d and prc-ann<>tuntccmcn~t pcn'i<~d (+:\Rs for (~;m down~gratlcs suggest th:tt, while p;trtially anticip;ttcd, the chm'ngv;tde itself is viewed ;~s very Imcl news by the market. T h e I.tct th:tt F,rc-atmsohttc tcrtns Ibr low t'atcd issttcs c<,~tr;tthcsis tlmt the I'e;lc'ti()ll to downgraclcs a m o n g h i g h e r rdtcd issues is s,mtllcr I>cc;msc they arc m o r e closely fob lowed. Since both ;tnnwcr rated issues, it is pt,ssible that the sigttificant positive coclficicnt Ibr CAR(-4:3,-1) in "l'al~lc 4 m,tv have been because this van'iablc was i)r<>xyin~g tbr the rating level. In the I:tst coltutnx~ o1" "i',tl+lc 4, we r e p o r t t'egx'essiott rcstnlts ;tttcr a d d i n g two new v;~riablcs to rcltcct this p<~ssil~ility. SPEC_(;I,H) cgtmls 1 Ibr d<~wngr;tclcs withiu the Sl~Cct~lativc gr;~tlc c,~tcgo~ 7 and <1 otherwise. F.-\I.I.EN cqtmls I tbv d<~wngvadcs From im'cstm<.'nt to spccul:ttive gt'adc (so c,tllctl "tullcn

STOCK MARKET REACTION TO BOND RATING CHANGES

111

angels") a n d 0 otherwise..-ks shown in the table, b o t h o f these variables are n e g a tive, indicating that, ceteris paribus, the m,trket reaction tends to be g r e a t e r to d o w n g r a d e s to a n d within the speculative categoD'. T h e variable CAR(-45.-I) is still positive a n d signiticant indicating that, even after c o n t r o l l i n g fi)r the rating level, the reaction is g r e a t e r , the g r e a t e r the p r e - , m n o u n c e m e n t CAR.

Ill.

CONCLUSIONS

We h.tve fi)tmd that the stock m a r k e t reaction to b o n d r a t i n g d o w n g r a d e s varies greatly d e p e n d i n g on the n a t u r e of the d o w n g r a d e . In general, the m a r k e t reacts m o r e strongly to d o w n g r a d e s at the lower e n d o f the rating scale. O n the o t h e r h a n d , the m a r k e t reaction is not strongly related to the n u m b e r o f levels the rating is r e d u c e d . For e x a m p l e , the i m p l i c a t i o n is that the stock m a r k e t reaction to a d o w n g r a d e fi'om 132 to B'~; is s t r o n g e r than the reaction to a downg r a d e f r o m A2 to A3 or even to a downgrade f r o m Aa3 to A3 attd no w e a k e r than the reacti~m to a d o w t l g r a d e f r o m BI to B:',. We also find that the reaction to d o w n g r a d e s is s t w m g c r if the fit+ufs pveannotttlc<+'i|lelll a b n o , ' m , d i'etttt'tls have b e e n n e g a t i v e ;.trial large. Since downg r a d c s following p e r i o d s ot" s t r o n g ncg:ttive , t l m . r m a l r e t u r n s should not as surprising as thm',lgr,tdcs Iblhm'ing i>et'iods o f positive al>normal returns, we must c
the t.ttt Ihal the nlal'kcl I'e;.K'ii()ll is not d e l ) e n d e n l oll the mmd+en' o f g r a d e s the rating is re<>siti,+'cly related to pvc-dy the m,u'kct as p r o v i d i n g i n f o r m a t i o n on likely future e a r n i n g s bcl'thcsis that low rated debt m a k e s Ih'ms less ;IIII';,ICIiVC as t a k e o v e r targets.

NOTES

*Direct all corr<_.sl~ondc.ncc to: l.ottis 11. Etlcringlon. Oklahoma Bankc,'s professor of Fi,mnce. College of 15ttsincss Administration, University of ()kl.tho,na. 307 West Brooks. 205A Adams I lall. Ntwman, ()K 73019-O-t50 < I+FDERi N (;(~ CBAFAC.CBA. U()KN()R.EI)U>.

1. "l'hesc downgrades arc im'ariablv associated with vc D" large price declines so their exclusion lowers the mean ('AR's reported in the tables and weakens our rest,Its. .M~st t~t' tiles<: dt+wttgradcs art: clhlfin.ttcd by our t'eqtthen~ctlt that thc,c be no other almotmccmc,lt i,i tile II'.~J on days -1 throt,gh + 1. since m(,,,t (,1"these arc accoml)anicd by a t)ankruplo" ,)r dcl'auh an,l,,unccmcnl in the If'S]. Ill a I'cw cases in which the I),)nd wits t<.T or dcl~ltllt ;lllllOtlllCCIll¢lll ill the II'S] I)111 checks ,)f olhcr s<)urces revealed that these firms did file for I>;mkctq)tcy <,t-

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QUARTERLY REVIEW OF ECONOMICS AND FINANCE

dot.lull at some point. \Ve eliminate .ill since it appears likely th.it there was a bankruptQ or default ,lnnoullccmcnt which the IIL~/failed to report. '2. 27 of our ratiilg ch.ulgcs are for ASE thms; the rest are listed on the NYSE. 3. More downgrades than upgrades were d r o p p e d tionl this sub-sample because reorgalliz,ltions and rcstructurings during this p c l i o d ~ c l c almost invariably in the direction of increasillg leverage. 4. Wallslcv and Clainctic (18,";5) observe sigllilicant positive abllormal returns prior to upgrades and sigllificant negative ,ibllormal returns prior to those downgrades not preceded by a CreditWatch listing but not prior to downgrades preceded by a CreditWatch listing. Elayan, et al. (.1996) do observe sigililicallt abllormal returns prior to conlinertial p a p e r rating challges. 5. Since the relation may not be linear, the equation was also estimated using the log of NUM_GRD alld using separate dulluuy variables: the results basically parallel those presented below for NUM_GRD. 6. Wc rail all analysis of variance to test how much of die variation in CAR(0,1) could bc explailled by dill).'rences in the three rllcans. The rcsuhing P statistic was 0.49 which in liOl signitlcani. FOl" CAR(-45,-1 ), F = .69. 7. Agaiil wl~ lcslcd lhc ([iHcrt'llCC ill llirec lilt';illS USillg an analysis o[" Val'iiiilce. hi this cast', ]" : <~.19 which in signillc:inl ~ i l lhc .05 Icvcl.

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