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 pre-announcement drift with a subsequent reversal. For upgrades, the drift is smaller in magnitude and the reversal non-existent. In contrast to the pre-announcement 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.

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 pre-announcement drift with a subsequent reversal. For upgrades, the drift is smaller in magnitude and the reversal non-existent.

• • In contrast to the pre-announcement 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.