Market reaction to bond downgradings followed by Chapter 11 filings - filing under bankruptcy law - Financial Distress Special Issue

Financial Management (Financial Management Association), Autumn, 1993 by Keqian Bi, Haim Levy

What is the impact of a firm's bond downgrading on its stock price? When bond downgradings occur, can the stock market distinguish between those companies that later file for Chapter 11 and those that do not? If the stock market can indeed distinguish between the two cases, how early do the prices reflect it? Our paper will try to answer these interesting questions.

An investigation into the information value of rating companies' services is not new. Katz |10~, in one of the earliest works on bond rating changes, develops an event-oriented methodology for testing the efficiency of the bond market.(1) He concludes that no anticipation exists prior to a public announcement of a rating change. After the rating change, there is a lag of six to ten weeks before the yield-to-maturity fully adjusts to the new rating classification. Weinstein |14~ investigates whether bond rating changes contain new information by studying the bonds' prices during the time period surrounding the announcement of the change in ratings.(2) He concludes that the rating changes cause no significant price change during or after the announcement, and that adjustments in the market are made 18 to six months before the event. Thus, his study suggests that changes in ratings provide no new information. Pinches and Singleton |13~ study the effects of changes in bond ratings on the returns of stocks during the period from January 1950 to September 1972. For each stock, they derive its market return based on the stock's beta and measure the actual return against the expected return for a period of 30 months before to 12 months after a rating after a rating change. They conclude that the downgrading of bond, bonds provides no new information to the market. Finally, Griffin and Sanvincente |8~ use three different methodologies to study the effects of changes in ratings on common stock prices.(3) They find that although the upgradings of bonds have no effect on stock prices, downgradings do have a significant effect.

Gilson, John, and Lang |6~ study the market's ability to predict the success of financially distressed firms in restructuring their debt versus filing for bankruptcy. Using two-day mean market-model stock residuals from 1981-1985, they find that a negative average announcement return of -1.6% is associated with firms who successfully restructure their debt. A negative announcement return of -6.3, however, is associated with firms whose restructuring attempts ultimately fail. Their results indicate that the market, on average, correctly predicts firms' ability to restructure their debt.

Altman and Kao |1~ study the "drift" associated with rating changes for new bond issues. They find that there is a negative drift associated with an original issue that is subsequently downgraded, and a positive drift associated with an issue that is subsequently upgraded. These results are interesting in light of the empirical findings of our study, which show that the market, on average, is able to distinguish between firms experiencing identical downgradings where one subsequently files for bankruptcy and the other does not. Altman and Kao find that the "drift" of the downgrading event is much stronger than the "drift" of the upgrading event. Thus, rating agencies appear to be less responsive than the market when re-rating firms.

Hand, Holthausen, and Leftwich |9~ analyze the effect of bond rating agency announcements on bond and stock prices. They also analyze the daily excess returns associated with the announcement of additions to Standard & Poor's Credit Watch list. They find that there is no announcement effect for additions to the S&P Credit Watch list, but there is a significant excess return when the changes in the S&P Credit Watch list are classified as "unexpected."

Using the event-study methodology, we examine the announcement effect of the "first consistent downgradings" of bonds on stock prices. As later defined in more detail, the "first consistent downgradings" are the earliest in a series of downgradings, with no upgradings during the sample period. We also distinguish between firms whose bonds are downgraded and who later file for Chapter 11 and those firms with identical downgrades that do not file for Chapter 11.

We find that the market, on average, is able to distinguish between firms having identical downgradings when one subsequently files for Chapter 11 and the other does not. This implies that the market behaves as if it assigns an even lower grade to the bonds of the company that later files for Chapter 11 than was assigned during the down-grading downgrading by Standard & Poor's or Moody's. Because we find empirically that almost two years elapse between the first consistent downgrading and the Chapter 11 filing, our results point to a high degree of market insight into the future prospects of companies.

The methodology employed in this study is set forth in Section I. Section II provides the empirical results. Concluding remarks are given in Section III.