Cross-Sectional Variation in Stock Price Reaction to Bond Rating Changes: Evidence from India (Empirical Results-4)

All the P/B portfolios exhibit anticipation in pre -event period. In downgrades, the direction of CAAR is different. In high P/B firms, the signalling effect is anticipated and dominant. This is so because such companies may have better disclosures which give the shareholders a fair idea about the earnings position of these firms. In the low P/B companies there may be information problems which make anticipation of earnings difficult. However, the wealth redistribution effects are easier to anticipate. Thus, these firms exhibit positively significant returns before downgrade. The direction of pre – event CAAR also differs in case of upgrades. For high P/B firms, a positive impact is seen on the share prices because of strong signalling effect. This observation is in line with expectation that these companies disclose information in a timely manner leading to occurrence of abnormal returns in the pre – event period. However, in low P/B firms, wealth redistribution effect offsets the positive earnings signal leading to negative CAAR.
Stock Liquidity based Portfolios – Panel C of Table 2 shows results of stock liquidity based portfolios. The relationship between bond rating changes and stock returns differs for illiquid and highly liquid stocks only in case of upgrades. The results show that firms with high trading volume exhibit wealth redistribution effect in case of upgrades whereas the firms with low trading volume demonstrate signalling effect. This may be because high liquidity firms may have more transparency so earnings signal may already be reflected in share prices and wealth redistribution effect may, therefore, dominate. But less liquid stocks are more difficult to value and therefore, the rating upgrades give a strong earnings signal in case of such firms.
However, post – downgrades, wealth redistribution effect is shown by both the portfolios. It is observed that the post downgrade CAAR for stocks with low trading volume is 0.080 which is higher as compared to CAAR of highly liquid stocks (0.035). So the response to bond rating downgrades is stronger in case of illiquid stocks.
No significant reaction is seen before the downgrades for illiquid stocks (small trading volume). The lack of anticipation is in line with the premise that illiquid firms may have few interested investors and these firms may not be closely monitored for major changes. On the other hand, for the firms whose shares are frequently traded, positive pre – event abnormal returns are observed. This is due to the possible close watch kept by the stockholders for any material changes in the capital structure or earnings situation of these companies. Liquidity, therefore, seems to be the criteria for pre empting information about the downgraded stocks.

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