DP9108 Bond Ratings Matter: Evidence from the Lehman Brothers Index Rating Redefinition

Author(s): Zhihua Chen, Aziz Lookman, Norman Schürhoff, Duane J Seppi
Publication Date: August 2012
Keyword(s): Corporate bond market, Index addition, Industry practices, Institutional investors, Liquidity, Market segmentation, Rating agencies, Rating-based regulation
JEL(s): G12, G14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9108

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.