Predictable and statistically significant patterns in cumulative abnormal returns on investment-grade (IG) euro-denominated corporate bonds occur around the announcement of downgrades by one or both of the major rating agencies as well as after deletion from IG benchmark indexes.
The authors focus on the price behavior of fallen angels around the announcement of their credit risk downgrade by either one or both of the major rating agencies, as well as around the time of rebalancing of the investment-grade (IG) benchmark indexes. Once downgraded by Standard & Poor’s and Moody’s, the bonds must be removed from institutional portfolios constrained to invest in only IG securities. The institutional selling pressure results in negative cumulative abnormal returns (CARs) for the bonds before and after the downgrade announcements. More importantly, even though the bonds’ CARs continue to be negative until the time of rebalancing of the benchmarks, prices significantly bounce back after the rebalancing, resulting in significant positive CARs for the fallen angels.
How Is This Research Useful to Practitioners?
Fallen angels are corporate bonds that were previously rated IG by one or both of the two major rating agencies—Standard & Poor’s and Moody’s—but have subsequently been downgraded to high-yield (HY) or junk bond status by both agencies. At that point, they must be removed from all benchmark indexes that represent IG securities.
The authors identify three major categories of institutional portfolios affected by the downgrade of IG bonds to fallen angels: insurance funds that need to adhere to regulatory constraints based on credit rating, exchange-traded funds that passively follow IG benchmarks, and mutual funds that are subject to tracking error restrictions. Offloading of the fallen angels by these major institutional portfolios, which form the bulk of OTC trades in the corporate bond market, results in price pressure on the fallen angels that is directly attributable to the credit risk downgrade.
When the benchmark index is rebalanced at the end of the month, the price of the fallen angels bounces back to reflect its true market value with respect to its new HY peers. The authors believe this finding to be their most original and important finding from this research. The reversal of fallen angel prices after the benchmark index rebalancing presents a structural incentive to corporate bond portfolio managers to drift from the benchmark. The authors observe that portfolio managers who are following IG benchmarks need to carefully time the selling of fallen angels and imply that managers of IG portfolios can avoid loss of value by holding the fallen angels until after prices adjust once they are dropped from the benchmark. They also observe that portfolio managers of HY portfolios can take advantage of the loopholes in index rebalancing by overweighting fallen angels around the day of their deletion from the benchmark because fallen angels tend to outperform their new HY peers by a significant margin.
How Did the Authors Conduct This Research?
The authors focus on euro-denominated corporate bonds. They use the Merrill Lynch EMU Non-Financial Corporate Index as their benchmark index and determine which bonds exited between January 2001 and December 2009. The final sample consists of 85 liquid bonds issued by 48 large industrial firms. They use daily price data from Bloomberg to calculate CARs of bonds deleted from the index during the period based on three events: (1) the announcement of the first downgrade to junk status by one of the two rating agencies, (2) the downgrade by the second rating agency that confirms the fallen angel status of the bond, and (3) the deletion of the bond from the benchmark at the end of the month or the rebalancing of the index.
The authors find negative CARs on the announcement day and in the month preceding the announcement of the first event. They also find significant negative CARs around the second event. The market reaction to the second event is much stronger than to the first event, and the reaction is independent of the size of the issue or the nationality of the issuer. But it is dependent on the performance of the overall IG bond market in the month prior to the downgrade, with the pressure higher (lower) on prices of fallen angels if the credit spreads widened (narrowed) over the previous month.
In the case of the third event, although the negative CARs continue in the month preceding the actual rebalancing, there are no significant CARs close to the event itself because the index rebalancing rules are known in advance to investors and convey no new information. But there are positive and significant returns in the post-event window. The authors establish through a regression analysis that the overperformance of the fallen angels compared with their HY peers is directly proportional to the strength or magnitude of the negative impact of the previous downgrade announcement on the bond’s price.
The authors highlight important issues regarding index rebalancing and its timing and predictability. Their analysis shows patterns of returns strong enough to have tactical portfolio management strategies built around them to take advantage of the abnormal price decline in fallen angels and the subsequent price reversal. The findings have important implications for portfolio managers of HY and IG portfolios. The authors have made excellent observations regarding the need to revisit portfolio management constraints as well as the need to design more effective index rebalancing rules to remove such structural irregularities that give rise to abnormal selling pressures on bond prices.