Why ratings matter: Evidence from Lehman’s index rating rule change. Working Paper

Abstract

Abstract 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. JEL Classification: G12, G1