Working Paper: CEPR ID: DP9108
Authors: Zhihua Chen; Aziz Lookman; Norman Schrhoff; Duane J. Seppi
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.
Keywords: corporate bond market; index addition; industry practices; institutional investors; liquidity; market segmentation; rating agencies; rating-based regulation
JEL Codes: G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Lehman redefinition (G33) | split-rated bonds with favorable Fitch ratings exhibit positive abnormal returns (G12) |
| favorable Fitch ratings (G24) | increased demand from ratings-sensitive investors (G24) |
| high-yield bonds with favorable Fitch ratings (G12) | abnormal return (G14) |
| Lehman redefinition (G33) | reduced ambiguity surrounding investment-grade status of bonds (G12) |
| reduced ambiguity (D80) | increased net demand and trading volumes (G15) |
| trading behavior of insurance companies (G22) | shifted towards upgraded bonds (G12) |
| Lehman announcement (G33) | bond pricing (G12) |