The Impact of Bond Rating Changes on Corporate Bond Prices

I examine the corporate bond market reaction to bond rating changes using newly available corporate bond transaction data from the over-the-counter (OTC) market. I document significant price responses to both downgrades and upgrades in the in two-day period surrounding announcements. Since numerous studies find no evidence of a stock price reaction do upgrades, my findings adds to the literature by showing that both upgrades and downgrades have a significant impact on prices of corporate bonds. In addition, I find that downgrades tend to follow periods of negative excess bond returns, a result that is consistent with prior literature and the contention that rating downgrades tend to be lagged indicators of deteriorations in credit quality. Hypothesizing that the corporate bond market reaction depends on both the degree of surprise and the importance of the information conveyed in the announcement, I analyze how the bond market reaction varies according to price movements prior to the announcement and across bond issues. The reaction to downgrades is stronger for bonds that experience positive excess returns prior to the announcement, indicating that price movements prior to a downgrade reflect the degree of surprise. The response to upgrades is much stronger for changes that revise bonds from speculative grade to investment grade, a result that likely reflects significant differences in the markets for investment grade and speculative grade debt. The reaction to both upgrades and downgrades is stronger for lower rated bonds, which suggests that bond prices become more sensitive to the information conveyed in rating changes as the issuer moves closer to bankruptcy. For both upgrades and downgrades, the bond market response is not strongly related to the number of grades that the rating is changed or the issue’s maturity, nor does it differ significantly if the e bond was placed on the rating agency’s watch list prior to the rating change.