Cross-Sectional Variation in Stock Price Reaction to Bond Rating Changes: Evidence from India (Empirical Results-3)

Cross-Sectional Variation in Stock Price Reaction to Bond Rating Changes: Evidence from India (Empirical Results-3)Price to Book Value (P/B) Based Portfolios – Panel B of Table 2 shows results of Price to Book Value based portfolios. The firms classified on the basis of P/B ratio differ in their response to bond rating changes after downgrades. While no significant reaction is seen for high P/B firms after downgrades, for low P/B firms a strong wealth redistribution effect is observed. This may be because in high P/B firms, both the signalling and wealth redistribution effect cancel each other. Alternatively, it can be said that the entire impact of the information leading to downgrades may have been absorbed in the pre – event period and, therefore, no significant CAAR is observed after the downgrade.
On the other hand, the fundamentally weak6, low P/B companies demonstrate abnormal returns after announcement. They show significantly positive abnormal returns after downgrade. The positive impact may come from possible increase in leverage of the firms which changes the risk profile of the firm. These companies initially under react to the information leading to rating downgrade during the pre – event period and the effect continues in the post – event period as well, bringing positive abnormal returns later.
In case of upgrades, however, both high as well as low P/B portfolios exhibit signalling effect after announcement.
Moreover, the relationship between bond rating changes and stock returns is more pronounced for low P/B firms compared to high P/B firms. This is indicated by the presence of strong abnormal returns for low P/B firms both after downgrades as well as upgrades. This is particularly evident in case of downgrades where no significant reaction is observed for high P/B firms after downgrades but for low P/B firms a strong wealth redistribution effect is seen after the announcement of rating downgrade. The value of CAAR in their case increases from 0.040 before to 0.070 after the announcement of downgrade.
Also in case of upgrades, the stock return behavior of low P/B portfolio shows a stronger response than high P/B firms. The CAAR value for high P/B portfolio is only 0.017 whereas in case of low P/B portfolio the CAAR is 0.023 after upgrade. For low P/B portfolio the sign of CAAR changes from negative to positive after upgrade announcement. In this case a strong positive signal on announcement of upgrade overcomes the negative wealth redistribution effect prevailing in the pre – event period. This may be because for low P/B firms there is less reliable public information. The negative abnormal returns before announcements of upgrades may be due to the wealth redistribution or because the ongoing developments may not be clear to the shareholders and the uncertainty lead to fall in prices, but the upgrade announcement sends a clear positive signal leading to positive returns after the upgrades. Thus, it can be concluded that low P/B firms respond more strongly to bond rating changes than high P/B firms.

Tags: , , , ,