Non-Linear Effects of Bond Rating Changes

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, Mertontype 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.