Why Ratings Matter: Evidence from Lehman's Index Rating Rule Change

Abstract

This paper examines the role of bond ratings and the effects of rating-based regulations in the corporate bond market. Exploiting an unanticipated mechanical change in how the benchmark Lehman bond indices are constructed in 2005, we show that rating-induced market segmentation of the bond market into investment-grade and high-yield sectors has a first-order impact on bond prices. Bonds that are mechanically upgraded to investment-grade due to the Lehman announcement have positive abnormal returns of two percent on average and exhibit abnormal order flows over several months. The abnormal bond returns are larger for bonds with longer maturities and higher turnover. We find that institutional investors with rating's-based portfolo constraints substantially increase their holdings in the aected bonds. In addition, return correlations with the investment-grade index increase for the upgraded bonds. Bonds on watch for downgrade to high-yield but with favorable Fitch rating experience reduced selling and rapid price recovery.Corporate bond market, rating agencies, rating-based regulation, market segmentation, liquidity, index addition, institutional investors