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Bond Ratings Matter: Evidence from the Lehman Brothers Index Rating Redefinition

  • Chen, Zhihua
  • Lookman, Aziz
  • Schürhoff, Norman
  • Seppi, Duane J

The 2005 inclusion of Fitch ratings in the Lehman composite index ratings provides a quasi-natural experiment to identify rating-based market segmentation in the corporate bond market. Split-rated bonds with favorable Fitch rating that were mechanically upgraded to investment-grade status exhibit abnormal returns and order flows, whether or not they enter the Lehman investment-grade index itself. An asymmetric impact of favorable Fitch ratings on bonds around the HY-IG boundary whose index rating did not initially change suggests that mechanical changes in future index rating transition probabilities also affect bond pricing. Our results highlight the importance of rating-based industry norms and practices for market segmentation, in addition to rating-based regulation.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 9108.

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Date of creation: Aug 2012
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Handle: RePEc:cpr:ceprdp:9108
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