Market reactions to the credit risk announcements by Jungsoon Shin January 24 th 2008 A dissertation submitted to the Faculty of the Graduate School of the State University of New York at Buffalo in partial fulfillment of the requirements for the degree of Doctor of Philosophy Department of Finance & Managerial Economics UMI Number: 3291588 3291588 2008 UMI Microform Copyright All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, MI 48106-1346 by ProQuest Information and Learning Company. Dedicated to EunDong Shin and KyungBun Park, Parents And Misook Choi, Wife For their consistent care and support. ii Acknowledgements Completion of dissertation marks an end of my academic training and the beginning of my professional life. Reflecting on my experience of doctoral years, I am deeply indebted to Dr. Kee H. Chung for serving as my dissertation chair. Without his guidance and encouragement, I would not have come to completion of doctoral study. I would like to thank two other committee members, Dr. Joseph P. Ogden and Dr. Kenneth A. Kim. Dr. Ogden’s constructive comments have been useful. As a coordinator in doctoral program, Dr. Kim provided me with invaluable advices. I am also grateful to Dr. Michael S. Rozeff. He has taught me two doctoral seminars, instilling deep academic insight. I am honored to discuss academic issues with finance faculty in the class and in the seminar presentations. Being with them has meant a great deal to me. iii Table of contents Dedication ii Acknowledgement iii Abstract vi Essay 1: Credit ratings and market liquidities 1 Introduction 1 2 Related literatures 6 3 Data and descriptive statistics 8 4 Measurement of variables 10 4.1 Liquidity and other market microstructure variables for corporate bond market 10 4.2 Liquidity and other market microstructure variables for stock market 11 5 Empirical results 13 5.1 Pre-credit and post-credit rating announcement tests 13 5.2 Unconditional tests using the event study methods 16 5.3 Conditional tests using the event study methods 19 5.4 Cross sectional regression analysis 21 5.4.1 Regression results for corporate bonds 21 5.4.2 Regression results for stocks 23 6 Transaction cost determinants 24 6.1 Transaction cost determinants in bond market 25 6.2 Transaction cost determinants in stock market 26 7 Conclusions 27 iv Essay 2: The effect of credit announcements on bond and stock prices 1 Introduction 51 2 Credit rating process and hypotheses development 56 2.1 Credit rating and watchlists 56 2.2 Credit rating agencies practices and objectives 57 2.3 Testable hypotheses 58 2.3.1 Information contents between reviews and rating actions 58 2.3.2 Market impact on categorical credit rating levels 58 2.3.3 Bond market versus stock market 59 2.3.4 Conflict of interests hypothesis 60 3 Data and descriptive statistics 60 4 Measurement of abnormal bond and stock returns 63 4.1 Measurement of abnormal bond returns 63 4.2 Measurement of abnormal stock returns 65 5 Unconditional (Unconditional) market impacts on the bond and stock markets 66 5.1 Unconditional tests of market impacts on bond and stock markets 66 5.2 Conditional tests of market impacts on the bond and stock markets 68 6 Regression analyses of abnormal returns around watchlists dates 71 7 Cross sectional analysis of anticipation hypothesis 73 8 Conclusions 74 v vi Abstract Essay 1: Using the extensive datasets, we analyze the effect of credit rating announcements on the bond and stock liquidities. We show that the average transaction costs increases (decreases) after downgrade (upgrade) credit rating news events. We interpret these results as evidence that liquidities improve or deteriorate following upgrade or downgrade announcement. We also find more pronounced phenomenon among the lower credit rated securities. That is, securities with poorer credit quality respond more strongly to the news announcements. Lastly, we report that the watchlists announcement convey more information contents than real rating changes. Essay 2: Using the traditional event study methodology, we examine the effect of Moody’s credit rating announcements on the bond and stock prices. We show that the cumulative abnormal bond and stock returns are positive (negative) and significant for the upgrade (downgrade) credit rating news events. We also find more prominent results among the lower credit rated bonds and stocks. For the highest quality group of bonds and stocks, we find meager and insignificant reaction to the news announcements. We also report that the rating reviews announcement release has more information contents than following rating changes. Essay 1: Credit ratings and market liquidities 1. Introduction Liquidity is the ability to trade large quantities quickly, at low cost, when investors want to trade. It is one of the most important characteristics in well-functioning markets. Conceptually, transaction costs are closely related to liquidity because transaction costs are low in a liquid market. Market microstructure studies have generated numerous papers concentrating on stock markets regarding these issues (e.g., Benston and Hagerman, 1974; Demsetz, 1968; Glosten and Milgrom, 1985; Huang and Stoll, 1996; Kaul and Nimalendran, 1991; Roll, 1984; Stoll, 1978, 1989, 2000). On the other hand, just a few studies offer analytical and experimental evidence regarding the bond transaction costs. Whereas Chakravarty and Sarkar (2003) find that the bid– ask spread is lower for higher credit rating bonds, Schultz (2001) reports that the liquidity pattern is not associated with credit risk. Edwards, Harris, and Piwowar (2007) find secondary corporate bond transaction costs increase with credit risk. However, none of these studies consider the effect of credit rating announcements on the liquidity of either the stock or the bond market. 1 The primary cause for the paucity of research on the fixed income markets is that reliable data were not available until recently. Not surprisingly, some prior works have relied on weekly or monthly data to study the corporate bond market. 2 In this study, we examine the short-run performance of both stock and corporate bond market transaction costs with different credit risk profiles when there are credit news announcements. Specifically, we address following questions: 1. How do credit rating announcements such as watchlists and rating changes affect 1 Liquidity, transaction cost, and bid–ask spread are used interchangeably in this paper. 2 Katz (1974) investigates monthly yield changes, Grier and Katz (1976) examine monthly bond returns, and Hite and Warga (1997) also study monthly abnormal bond returns. 1 liquidities? Specifically, are upgrade (downgrade) news events associated with increased (decreased) liquidity changes? If so, which announcement between watchlists or rating changes has more impact on the liquidities? 2. Are liquidity changes similar across the credit rating level? For example, will highly rated bonds respond to rating announcements in a similar way as poorly rated bonds? 3. Is there any structural difference between the bond and stock market in terms of liquidity changes? 4. Do asymmetric reactions exist between downgrade and upgrade news announcements? Harris and Piwowar (2006) and Edwards et al. (2007) note that bonds with lower credit risk are more expensive to trade, which is consistent with adverse selection risk theory in the market microstructure literature. Odders-White and Ready (2006), who report similar findings in the stock market, show that firms with greater risk of private shocks—and, therefore, higher levels of equity–market adverse selection—have lower credit ratings. Higher adverse selection risk on lower rated bonds is consistent with the general notion of the corporate bond market. Institutions such as insurance companies, mutual funds, and public pension funds are the main investors for corporate bonds. According to regulations, they are required to buy and hold quality bonds, and, thus, do not actively trade high-yield bonds. However, compared with these institutional investors, relatively less regulated hedge funds actively trade speculative bonds. Therefore, information-based trading is more likely to occur on lower rated bonds. Chakravarty and Sarkar (2003) argue that based on the inventory model in a market microstructure, dealers’ costs of adjusting inventory should be incorporated into the bid–ask spread, implying that transaction costs increase with the risk of the security. 3 Therefore, to the 3 Refer to Garman (1976), and Chakravarty and Sarkar (2003) for the inventory hypothesis. 2 extent that transaction costs increase with credit risk, we expect that the bid–ask spread will increase (decrease) with a downgrade (upgrade) credit rating announcement. In other words, liquidity will improve (deteriorate) with an upgrade (downgrade) credit news event. Furthermore, following similar logic, more pronounced spread changes will be detected on speculative-rated bonds compared with high-quality bonds because informed trading is more likely to occur on lower rated bonds, causing dealer inventory imbalance. The stock market has strived to improve transparency. To enhance the ability of market participants to observe information regarding pretrade order flow and posttrade price and quantity, several rules have been made or changed (Boehmer, Saar, and Yu, 2005; Chung and Zhao, 2007). Although transparency in the corporate bond market improved following the introduction of the Trade Reporting and Compliance Engine (TRACE) system in 2002, it is not yet comparable to stock market. In addition, the bond market is less liquid than the stock market in terms of trading activity. If we assume that market transparency and liquidity are important factors in market efficiency, we can conclude that the corporate bond market is less efficient than the stock market. 4 Based on these arguments, we conjecture that information regarding credit rating announcements will be more efficiently incorporated into the stock market than the bond market, so that liquidity transitions will be better detected in the stock market. We separate the short-term effects of two related announcements regarding credit rating: watchlists and rating changes. Specifically, watchlists, sometimes referred to as rating reviews, are the statements made by a full rating committee prior to the actual rating change announcements. 5 For stability purposes, the rating agencies tend to make subsequent rating 4 Transparency is related to the market efficiency. Bloomfield and O’Hara (1999) show that trade transparency increases information efficiency. 5 Moody’s uses watchlists and rating reviews interchangeably. 3 [...]... determinants in the stock market Thus, after controlling the bond-specific factors, we can examine how traditional market microstructure theories apply to the bond market We perform a similar test for the stock market to see whether credit risk explains the variations in transaction cost determinants after controlling the relevant variables 6.1 Transaction cost determinants in bond market Panel A of... results for both the corporate bond market and the stock market and find that the reaction to announcements is more prominent in stocks than in bonds We attribute these results to the more liquid and efficient characteristics of the stock market Although the introduction of TRACE greatly improved transparency in the bond market, we believe, in line with Edwards et al (2007), that more actions to improve... explore the factors that influence the transaction costs not only in the corporate bond market but also in the stock market Compared with studies of the stock market, few papers have investigated the determinants of transaction costs in the bond market Chakravarty and Sarkar (2003) find that maturity, trading volume, and credit ratings are key determinants of the bid–ask spread However, their results... announcements on liquidity in terms of transaction costs As far as we know, this study is the first to model and test the behavior of bond and stock liquidities around credit rating announcements Second, we report the results of both the corporate bond market and the stock market By comparing both markets, we confirm that the stock market is more liquid and 8 For issuer characteristics, we control for leverage,... compare the highest and lowest categories, we find that the transactions cost for stocks graded A and above is 0.26% and for stocks graded C and below is 1.79%, which is six times greater When we compare the stock and bond markets, we find that transaction costs are lower in the stock market Unlike the corporate bond market, the number of trades and trade size are negatively associated with credit risks These... according to upgrade or downgrade announcements We also find more pronounced phenomenon among the lower credit rating bonds That is, bonds with poorer credit quality respond more strongly to news announcements, which is also observed in stock market Using the traditional event methods, we calculate three-day CASs to test whether an announcement effect is found around the credit review and credit change... securities The negative and significant coefficient for trade size in the stock market is also consistent with traditional market microstructure theory In the second regression, we add 29 Edwards et al (2007) interpret the positive coefficient for inverse price as fixed cost in the bond market that traders pay for clearance 25 dummy variables for Baa, Ba and B, and A and above to see whether credit risk. .. changes in bid–ask spreads cannot be attributed to changes in issue attributes 9 We apply the same tests to the stock market and obtain the similar results In addition, the magnitudes of rating announcement effects are greater for the stock market than corporate bond market in the cross sectional analysis Finally, we run a cross-sectional regression for the determinants of transaction costs Consistent... watchlist events are driven by other factors, we run cross-sectional regression analyses We find that our results are not driven by bond (stock) specific factors We investigate transaction cost determinants in both the corporate bond market and the 27 stock market After controlling relevant independent variables, we find that credit risk provides additional explanatory power to the transaction cost variations... However, more interesting, we obtain the similar results for the stock market because prior studies have not investigated the relation between credit risk and transaction costs Furthermore, we find more pronounced 18 Chen, Wang, and Wu (xxx) report that the corporate bond market is less informationally efficient than the stock market, based on various specifications of the volatility–volume model 15 increases/decreases . is the first to model and test the behavior of bond and stock liquidities around credit rating announcements. Second, we report the results of both the corporate bond market and the stock market. . (Unconditional) market impacts on the bond and stock markets 66 5.1 Unconditional tests of market impacts on bond and stock markets 66 5.2 Conditional tests of market impacts on the bond and stock markets. effect of credit rating announcements on the liquidity of either the stock or the bond market. 1 The primary cause for the paucity of research on the fixed income markets is that reliable