The Index Effect in the Corporate Bond Market

Abstract

The author finds large and statistically significant abnormal returns of USD-denominated corporate bonds, which were up- or downgraded in the Bloomberg Barclays Investment Grade and High Yield Index from 2012 to 2018. Downgrades face a strong negative preannouncement drift with a subsequent reversal. For upgrades, the drift is smaller in magnitude and the reversal nonexistent. In contrast to the preannouncement drift, the reversal seems to be related to price pressure, which is caused by index-linked trading. This hypothesis is supported by an analysis of actual exchange-traded fund trading behavior with respect to credit rating changes.

TOPICS: Fixed income and structured finance, exchange-traded funds and applications

Key Findings

• • There are large and statistically significant abnormal returns of USD-denominated corporate bonds, which were up- or downgraded in the Bloomberg Barclays Investment Grade and High Yield Index from 2012 to 2018.

• • Downgrades face a strong negative preannouncement drift with a subsequent reversal. For upgrades, the drift is smaller in magnitude and the reversal nonexistent.

• • In contrast to the preannouncement drift, the reversal seems to be related to price pressure, which is caused by index-linked trading. This hypothesis is supported by an analysis of actual ETF trading behavior with respect to credit rating changes.