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Why Ratings Matter: Evidence from Lehman's Index Rating Rule Change

Author

Listed:
  • Zhihua CHEN

    (University of Neuchâtel, Shanghai University and SwissFinance Institute)

  • Aziz A. LOOKMAN

    (Moody's Investors Service)

  • Norman SCHURHOFF

    (University of Lausanne, Swiss Finance Institute and CEPR)

  • Duane J. SEPPI

    (Carnegie Mellon University)

Abstract

This paper examines the role of bond ratings and the effects of rating-based regulations in the corporate bond market. Exploiting an unanticipated mechanical change in how the benchmark Lehman bond indices are constructed in 2005, we show that rating-induced market segmentation of the bond market into investment-grade and high-yield sectors has a first-order impact on bond prices. Bonds that are mechanically upgraded to investment-grade due to the Lehman announcement have positive abnormal returns of two percent on average and exhibit abnormal order flows over several months. The abnormal bond returns are larger for bonds with longer maturities and higher turnover. We find that institutional investors with rating's-based portfolo constraints substantially increase their holdings in the a ected bonds. In addition, return correlations with the investment-grade index increase for the upgraded bonds. Bonds on watch for downgrade to high-yield but with favorable Fitch rating experience reduced selling and rapid price recovery.

Suggested Citation

  • Zhihua CHEN & Aziz A. LOOKMAN & Norman SCHURHOFF & Duane J. SEPPI, 2010. "Why Ratings Matter: Evidence from Lehman's Index Rating Rule Change," Swiss Finance Institute Research Paper Series 10-30, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1030
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    Citations

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    Cited by:

    1. Ellul, Andrew & Jotikasthira, Chotibhak & Lundblad, Christian T., 2011. "Regulatory pressure and fire sales in the corporate bond market," Journal of Financial Economics, Elsevier, vol. 101(3), pages 596-620, September.
    2. Becker, Bo & Milbourn, Todd, 2011. "How did increased competition affect credit ratings?," Journal of Financial Economics, Elsevier, vol. 101(3), pages 493-514, September.
    3. Darrell Duffie & Bruno Strulovici, 2012. "Capital Mobility and Asset Pricing," Econometrica, Econometric Society, vol. 80(6), pages 2469-2509, November.

    More about this item

    Keywords

    Corporate bond market; rating agencies; rating-based regulation; market segmentation; liquidity; index addition; institutional investors;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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