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Discussion Paper Details

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Title: Bond Ratings Matter: Evidence from the Lehman Brothers Index Rating Redefinition

Author(s): Zhihua Chen, Aziz Lookman, Norman Sch�rhoff and Duane J Seppi

Publication Date: August 2012

Keyword(s): Corporate bond market, Index addition, Industry practices, Institutional investors, Liquidity, Market segmentation, Rating agencies and Rating-based regulation

Programme Area(s): Financial Economics

Abstract: The 2005 inclusion of Fitch ratings in the Lehman composite index ratings provides a quasi-natural experiment to identify rating-based market segmentation in the corporate bond market. Split-rated bonds with favorable Fitch rating that were mechanically upgraded to investment-grade status exhibit abnormal returns and order flows, whether or not they enter the Lehman investment-grade index itself. An asymmetric impact of favorable Fitch ratings on bonds around the HY-IG boundary whose index rating did not initially change suggests that mechanical changes in future index rating transition probabilities also affect bond pricing. Our results highlight the importance of rating-based industry norms and practices for market segmentation, in addition to rating-based regulation.

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Bibliographic Reference

Chen, Z, Lookman, A, Sch�rhoff, N and Seppi, D. 2012. 'Bond Ratings Matter: Evidence from the Lehman Brothers Index Rating Redefinition'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=9108