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Why Ratings Matter: Evidence from Lehman's Index Rating Rule Change
EFA (European Finance Association) 2009 Bergen Meetings Papers
We examine institutional price pressure in corporate bond markets by exploiting an unanticipated mechanical change in how a Lehman's bond index is constructed. We show that bond market segmentation into investment-grade and high-yield sectors because of rating-based regulation has a first-order impact on security prices. Institutional investors with investment constraints increase their holdings of split-rated bonds that are now mechanically considered investment-grade instead of high-yield by Lehman, resulting in temporary order imbalances that creates positive price pressure. Bonds that are mechanically upgraded to investment-grade exhibit large capital flows and experience positive abnormal returns of 200 basis points over a two week horizon. Price reactions are transitory, however, and vanish after twenty to thirty days. Similarly, bonds that were expected to downgrade to high-yield but were mechanically upgraded also exhibit transitory positive abnormal returns and reduced net selling. Taken together, our results suggest that the demand curve for bonds is downward-sloping in the short run.
Institutional price pressure, rating-based regulation, market segmentation, index addition, corporate bond, institutional investors
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