Cross-Sectional Variation in Stock Price Reaction to Bond Rating Changes: Evidence from India (Empirical Results-5)

Cross-Sectional Variation in Stock Price Reaction to Bond Rating Changes: Evidence from India (Empirical Results-5)In case of upgrades, liquid as well as less liquid stocks show abnormal returns in the pre -event period. However, the direction of these returns is different. In case of less liquid (small trading volume) stocks, signalling effect is very strong and overcomes the wealth redistribution effect leading to a positive CAAR. On the other hand, in case of more liquid stocks, the wealth redistribution effect dominates and overcomes the signalling effect and negative abnormal returns are witnessed.
Financial Leverage based Portfolios- Panel D of Table 2 shows results of leverage based portfolios. The relationship between bond rating changes and stock returns differs in case of high leverage firms and low leverage firms. In case of rating downgrades, as expected, the high leverage firms show a strong response to rating change while low leverage portfolio do not show any significant CAAR. For high leverage firms the abnormal returns are positively significant both before and after the event because the firms which already have a high leverage are more risky and therefore any further change in leverage may be closely monitored by the shareholders. There is an increase in risk due to downgrades which prompts the investors to expect a higher return on their stocks. The downgrades occurring due to change in capital structure make the investment risky for the bondholders but may lead to transfer of wealth from bondholders to shareholders. Also, these are usually the firms with information problems and therefore the wealth redistribution effect is not fully absorbed in the pre – event window. The firms with low leverage show insignificant returns before as well as after the downgrade. This is because these firms are less risky and a downgrade, in particular, that which occurs in response to change in capital structure does not affect these firms very strongly.
The response of the two portfolios also differs in case of upgrades. In case of upgrades, while strong wealth redistribution effect explains results for high leverage firms, signalling effect dominates the firms with low leverage.
The firms with high leverage demonstrate strong wealth redistribution effect both in case of upgrades as well as downgrades. This is due to the reason that high leverage firms are more sensitive to wealth redistribution effects.

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