Non-Linear Effects of Bond Rating Changes

by Philippe Jorion of the University of California at Irvine, and
Gaiyan Zhang of the University of California at Irvine

March 2005

Abstract: This paper demonstrates the importance of the initial credit rating when assessing the effect of a bond rating change on the company's stock price. First, we provide theoretical support for different price effects as a non-linear function of the initial credit rating, using a structural, Merton type model linking the change in default probability to the change in the stock price. In particular, rating changes should have much greater effects when starting from a lower initial credit rating. This is strongly verified in the empirical data. Accounting for this non-linearity explains in large part the puzzling empirical regularity that stock price effects are associated with downgrades but not upgrades. In addition, it eliminates the investment-grade barrier effect reported in previous studies.

JEL Classification: G18, G14, G28, K22.

Keywords: credit rating agencies, market reaction, event study, default probability.

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