Cross-Sectional Variation in Stock Price Reaction to Bond Rating Changes: Evidence from India (Introduction-2)

Hence, a rating downgrade is associated with a decline in stock prices while an upgrade (or placement on a watch with positive indications) is associated with rise in stock prices.
Wealth redistribution hypothesis emphasizes that there is usually a conflict between the interest of bondholders and stockholders. The limited liability may prompt the stockholders to invest in riskier options to earn higher return. Such an approach increases the default risk of outstanding bonds forcing the credit rating agencies to downgrade the rating. This leads to a decline in the value of bond, which is transferred from bondholders to stockholders, leading to a rise in share price.

Conversely, a rating upgrade will lead to a decrease in stock prices. Holthausen and Leftwich (1986) and Zaima and McCarthy (1988) also suggest that if equity shareholders are viewed as holding an option on the value of the firm with an exercise price equal to the par value of the firm’s debt, then an increase in the variance of the firm’s cash flows would redistribute the wealth from bondholders to stockholders. The higher the volatility, the more the risk and thus the option pricing model for valuation becomes more relevant. Results obtained by Goh and Ederington (1993); Bhoot (1995) and Romero and Fernandez (2007) support wealth redistribution hypothesis.
The signalling and wealth redistribution effects work in opposite direction and may fully or partly offset each other.
Prior literature also shows that the price responsiveness to downgrades is more pronounced than upgrades. This confirms the asymmetric nature of relationship between bond rating changes and stock returns. Another notable issue is whether all the firms react in a similar manner to the information provided by the rating changes. There may be a differential response to new information in case of companies for which there is little or infrequent information compared to companies which are always in news. The former are much harder to value and arbitrage. For instance, small size, low price to book value (as a measure of relative firm distress as suggested by Chan and Chen (1991)), low liquidity, high asset intangibility, high leverage and low profitability firms are expected to exhibit stronger price reaction to bond rating information, owing to poor disclosures, lower investment analyst and media coverage, higher cost of trading, greater degree of uncertainty in estimating their cash flows and a greater likelihood of earnings management.

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