Information Effects of Bond Rating Changes : The Role of the Rating Prior to the Announcement

This paper shows that studies of announcement effects of bond rating changes should take into account the initial rating. First, we provide theoretical support for different price effects as a non-linear function of the initial credit rating, using a structural, Merton-type model linking the change in default probability to the change in the stock price. Next, we show that this theoretical prediction is verified in the empirical data. We find much stronger stock price effects for bond rating changes for low-rated firms relative to high-rated firms. Accounting for the role of the initial rating explains in large part the puzzling empirical regularity that stock price effects are associated with downgrades but not upgrades. In addition, it eliminates the investment-grade barrier effect reported in previous studies