Journal of Business Finance & Accounting, 26(3) & (4), April/May 1999, 0306-686X

The Independent Impact of Credit

Rating Changes ± The Case of
Moody's Rating Refinement on
Yield Premiums

Pu Liu, Fazal J. Seyyed and Stanley D. Smith*

1. INTRODUCTION

Bond ratings agencies produce information about the default

risk of debt issues and sell the information to investors. They also
charge the bond issuers a fee for rating the debt qualities. The
two most widely recognized rating agencies in the US are
Moody's Investors Service and Standard & Poor's Corporation.1
These agencies provide investors with a system of relative
creditworthiness of bond issues by incorporating all the
ingredients of default risk into a single code.
The ratings assigned by these agencies ± in particular, issues
related to their accuracy and incremental information content ±
have long been the focal point of policy debates on the
functioning of the nation's capital markets. Corporate executives
and local government administrators issuing bonds have
invariably shown great concern over these ratings, financial
institutions have found their investment portfolios influenced by
these ratings,2 and economists have considered ratings important

* The authors are respectively, Professor of Finance and Holder of Harold A. Dulan Chair,
Finance Department, University of Arkansas; Dean, The Imperial College of Business
Studies, Lahore, Pakistan; and SunTrust Chair of Banking and Professor of Finance,
Department of Finance, University of Central Florida. The authors are grateful to the
anonymous referee for the suggestions that considerably enhanced the paper. (Paper
received July 1997, revised and accepted September 1998)
Address for correspondence: Pu Liu, Professor of Finance, College of Business
Administration, University of Arkansas, Fayetteville, Arkansas 72701, USA.
e-mail: pliu@comp.uark.edu

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338 LIU, SEYYED AND SMITH

enough to generate a voluminous literature on the subject.3 It

appears, therefore, that many interest groups would be well
served by an improved understanding of the role of bond ratings
in the determination of equilibrium yields.
Studies have shown that there is a strong association between
the credit rating assigned and the eventual payoff of interest and
principal obligations.4 It is also well known that interest rates for
bonds are negatively correlated with credit ratings. Still in dispute
is whether or not the ratings convey information to investors in
addition to what they can deduce from publicly available
information about the bond issuers. That is, the ratings may
merely summarize information that has already been impounded
in prices, and to the extent that the summaries imparted through
the ratings are congruent with the market's information, their
correlation with yields is inevitable.5
The question of whether or not ratings contain new
information, as opposed to superfluous summaries of publicly
available information, is of interest to economists. Many
researchers have studied the impact of bond rating changes on
bond yields or stock prices to ascertain if bond or stock prices
were independently influenced by ratings. Although most studies
examine the impact of rating changes on stock prices, some studies
investigate the effect of rating changes on bond prices or yields.
Most early studies report that changes in bond ratings convey no
new information to the market. These studies include Pinches and
Singleton (1978, monthly stock returns), Wakeman (1978, weekly
bond returns and monthly stock returns), and Weinstein (1977,
monthly bond returns). By contrast, more recent studies have
detected significant security price changes following rating
changes. These studies include Goh and Ederington (1993, daily
stock returns), Griffin and Sanvicente (1982, monthly stock
returns), Hand, Holthausen and Leftwich (1992, daily bond
returns and daily stock returns), Holthausen and Leftwich (1986,
daily stock returns), Ingram, Brooks and Copeland (1983, monthly
bond returns), Matolcsy and Lianto (1995, daily stock returns),
Nayar and Rozeff (1994, daily stock returns) and Stickel (1986,
daily common stock returns and daily preferred stock returns).
A review of the literature in the above paragraph reveals that
most studies in the literature examined the response of stock
prices to credit rating changes, only a few papers investigated the

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impact of rating changes on bond returns or yields. Among those

studies that use bond returns or yields to examine the information
content of rating changes, most recent studies (e.g. Hand,
Holthausen and Leftwich, 1992; and Ingram, Brooks and
Copeland, 1983) find that rating changes have information
content, while earlier studies (e.g. Wakeman, 1978; and
Weinstein, 1977) report that rating changes do not have an
impact on bond prices.
But, even if there are security price changes associated with
rating changes, it is difficult to conclude that security price
changes were induced by the rating reclassification that preceded
them. It is quite possible that the change in the issuer's financial
characteristics that caused the rating to be altered was entirely responsible
for a movement in the security price also. In other words, the high
degree of correlation between the change in credit ratings and
the variability in security prices may reflect nothing more than a
common reliance of both ratings and security prices on these
financial characteristics, and thus, claims of causality between
security prices and ratings may be spurious.6
On April 26, 1982, seventy-three years after John Moody
introduced the bond ratings to the financial market, Moody's
Investor Service refined its rating system for the first time by
adding numerical modifiers to each rating category from Aa
through B. The modifiers 1, 2 and 3 indicated whether the debt
issues are ranked at the high end, the mid-range or the low end of
the generic category, respectively. While the purpose of Moody's
rating refinement is to give investors a more precise indication of
relative quality in each of the generic categories, the action of the
refinement also provides an extraordinary opportunity to test
whether the credit ratings issued by Moody's have an independent
impact on the yields over and above the publicly available
information such as financial news, earnings announcements, and
Standard & Poor's refined ratings which have existed in the
market since 1974.7 When the rating of a bond was refined by
Moody's from a generic category (for example, Aa) to a modified
category (Aa1, or Aa3, for instance), the modification in ratings
was solely caused by Moody's decision to move from one rating
system to another, rather than by the improvement or
deterioration of the bond issuer's financial positions. Thus,
employing the response of the market to the rating refinement we

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can examine whether credit ratings have an independent impact in

yields or prices and avoid the problem of a confounding effect.
Furthermore, the magnitude of rating revision caused by
refinement is minimal ± only one third of one generic rating
category. Therefore, the existence of information content
detected in rating refinement may suggest that rating changes
caused by the improvement or deterioration of issuers' financial
positions and/or rating changes which are more than the
minimal magnitude may have greater impact on security prices.
In this paper we test whether the prices of bonds respond to
the announcement of Moody's rating refinement. We find
statistically significant changes in yields for a combined bond
portfolio which includes both upward revised and downward
revised bonds. The findings suggest that rating refinement has an
independent impact on bond prices.
We further break down the combined portfolio into two
subportfolios ± one includes only downward revised bonds, and
one includes only upward revised bonds. We then examine each
portfolio individually. Although the yields for both portfolios
move in the hypothesized directions, we find statistically
significant yield changes only in the bond portfolio whose ratings
are revised downward, but not in the portfolio whose ratings are
revised upward. The results indicate that the significant changes
in yields for the combined portfolio are driven by the yield
changes in the downgraded portfolio and the results are
consistent with the findings of Griffin and Sanvicente (1982),
Hand, Holthausen and Leftwich (1992), Holthausen and
Leftwich (1986), and Matolcsy and Lianto (1995), who also find
that downgrading of bond ratings tend to have greater impact on
security prices than upgrading.
This paper differs from previous studies in that we can avoid
the possible confounding effect by using the rating refinement as
a vehicle for testing the information content of rating changes.
Throughout the paper, we will assume that the rating was an
upgrade if the modifier `1' was assigned, a no change if the modifier
`2' was assigned, and a downgrade if the modifier `3' was assigned.
The rest of the paper is organized as follows. Section 2
addresses the research methodology. Section 3 contains a
discussion of data and sample selection. Section 4 discusses
empirical results, followed by a conclusion in Section 5.

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2. RESEARCH METHODOLOGY

(i) Determination of Yield Premium

The approach used in this study to examine the impact of
Moody's rating refinements on bond yields is an event study
methodology. The procedure used in event studies involves
comparing actual returns of the security experiencing the event to
the benchmark returns estimated according to an equilibrium
model such as the market model. Thus, the benchmark returns
are the normal returns that would be expected in the absence of
the release of information, given the risk class of the security. The
actual returns are then compared to the benchmark returns and
the residuals are tested for significant difference from zero. While
the empirical appropriateness of the market models to stock
returns has been established, serious violations of the underlying
assumptions of the market model occur when the market is
defined as a debt index (Alexander, 1980).8 Consequently,
alternative procedures suitable for analyzing differential returns
among bonds are used. The methodology used in this study is
similar to that used by Barrett, Heuson and Kolb (1986a and
1986b), and Ingram, Brooks and Copeland (1983).
According to the approach taken by Barrett, Heuson and Kolb
(1986a and 1986b), and Ingram, Brooks and Copeland (1983),
yields on bonds can be decomposed into four components: the
general level of interest rates, a bond-specific component
reflecting the differences in coupon rates and terms to maturity
(thus the duration of a bond), a component reflecting capital
gains tax effect,9 and a component associated with the default
risk (the probability of not paying principal and interest). The
rating refinement has an impact on yields only through the
component related to the default risk. However, bond issues in
our sample have different coupon rates, terms to maturity and
capital gains tax effects, and these differences must be
controlled. Furthermore, we examine the yields on bonds during
a 22-week period from 13 weeks before to 8 weeks after the
announcement of rating refinement. The variation in the general
level of interest rates during the 22 weeks introduces another
variable that will have an impact on yield. This variable also needs
to be controlled.

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342 LIU, SEYYED AND SMITH

The methodology used to control for these three variables and

thus measure the `net' effect of rating refinement on yields is the
`differential yield premium' method developed by Ingram,
Brooks and Copeland (1983) and extended by Barrett, Heuson
and Kolb (1986a and 1986b).
The yield premium for each corporate bond in the sample for
each week is defined as the difference between the yield to
maturity of each corporate bond and the estimated yield to
maturity of a Treasury bond with the same coupon rate, maturity,
and discount from face value (which reflects the capital gains tax
effect). Thus, the yield premium for each bond j in period t for
the 22-week period is calculated as:
YPjt ˆ Y jt ÿ Y Tt …CR jt ; MATjt ; DISCjt †; …1†
where:
YPjt: yield premium on corporate bond j in period t;
Yjt: observed yield to maturity of corporate bond j in
period t;
YTt (CRjt, MATjt, DISCjt): estimated yield to maturity of a
Treasury bond in the sample, a Treasury bond T, with
equivalent coupon rate (CR), maturity (MAT), and
discount from face value (DISC) as bond j in period t.
Estimation of Treasury bond yields is necessary because it is
impossible to find, for every bond in the sample, a Treasury bond
with exactly the same maturity date, coupon rate and discount
from face value. The estimated yield to maturity for a Treasury
bond with a given coupon rate, maturity and discount from face
value, YTt(CRjt , MATjt, DISCjt) is obtained from the following
regression equation for each period t:
Y Tt ˆ a0t ‡ b1t CRTt ‡ b2t MATTt ‡ b3 DISCTt ‡ eTt …2†
where:
YTt: yield to maturity of a Treasury security T in period
t;
CRTt: coupon rate of a Treasury security T in period t;
MATTt: natural logarithm of maturity in months for each
Treasury security';
DISCTt: discount from the face value divided by the face
value of each Treasury security.

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 IMPACT OF CREDIT RATING CHANGES 343
A logarithmic transformation of maturity is used to account for
non-linear effects of maturity on yield as suggested by Ingram,
Brooks and Copeland (1983). And the variable DISC is used as a
proxy to capture the tax effect resulting from the favorable tax
treatment of capital gains relative to interest income which make
discount bonds more attractive to investors.10

(ii) Assessment of Information Content of Rating Refinement

In order to assess the impact of rating refinement on yield
premium, we compare the yield premium of each bond which
experienced the rating modification in the refinement process
(referred to as an `event bond') with the benchmark yield premium
of a bond in the control group (referred to as a `control bond').
The control bond is required to have similar issue-specific
characteristics such as the size of the issue (as measured by the
par value of the issue outstanding), sinking fund provision, call
provision, mortgage (security) status, except that the control bond
did not experience a rating modification in the refinement process.
Although the market-wide influences on bond yields are
controlled by computing the yield premiums, the issue-specific
characteristics may still have an influence on yield premium that
needs to be controlled in order to measure the net effect on
rating refinement on yield premium. The use of control bonds is
for the control of issue-specific characteristics. Practically, it is
difficult, if not impossible, to find a control bond to match each
event bond in terms of issue-specific characteristics. Hence, we
compare the yield premium of each event bond with the estimated
yield premium of a control bond which has the same issue-
specific characteristics as the event bond. Thus, we calculated the
differential yield premium for each event bond j for each period t
(DYPjt) as follows:
DYPjt ˆ YPjt ÿ YPCjt …3†
where:
YPjt: is the yield premium (recall equation (1)) for an
event bond j at time t;
YPCjt: is the estimated yield premium (at time t) of a
control bond which has the same issue-specific
characteristics as event bond j.

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344 LIU, SEYYED AND SMITH

The estimated yield premium for each period t is obtained from

the following regression equation:
YPCt ˆaot ‡ b1t MATc ‡ b2t SIZEc ‡ b3t SINK c ‡ b4t PROB CALLc
‡ b5t CALL DEFERc ‡ b6t CALL EXER PDc
‡ b7t MORTc ‡ et : …4†
where:
YPCt: the yield premium (calculated from
equation (1)) for each control bond;
MATc: natural logarithm of maturity in months
for each control bond;
SIZEc: par value of the issue outstanding for
each control bond;
SINKc: sinking fund provision, 1 if the control
bond includes a sinking fund provision;
0 otherwise;
c
PROB CALL : probability of call which is measured by
the ratio of current price of bond to call
price for each control bond;
CALL DEFERc: call deferment period is months for
each control bond;
CALL EXER PDc: call exercise period ± period in months
from expiration of call deferment to
maturity of bond for each control bond;
c
MORT : 1 if the control bond is a mortgage
bond; 0 otherwise.
The theoretical basis and empirical support for the selection of
control variables is presented later in this section. Based on
previous studies, the impact of the control variables may not be
uniform across rating categories.11 For this reason, separate
regressions are estimated for each rating category.
Since the impact of upgrading of bonds on yield premium, on
a priori basis, is expected to be the opposite of downgrading, the
bonds in our sample are segregated into two portfolios ± an
upgraded portfolio and a downgraded portfolio to avoid the
possible offset effect. To ascertain the information content of the
rating refinement, the average differential yield premium for the
upgraded and downgraded portfolios are calculated separately to
test for significant differences from zero.

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 IMPACT OF CREDIT RATING CHANGES 345

To assess the overall impact of rating refinement, we also pool

the bonds in the two portfolios into one combined portfolio.
Since the differential yield premium is expected to be negative
for upward revised bonds and positive for downward revised
bonds, we multiply the differential yield premiums for
upgraded bonds by ÿ1 and then average them with
downgraded bonds to test for a significant difference from
zero. This approach is equivalent to holding a short position in
the upward revised bonds and a long position in the downward
revised bonds.12

(iii) Discussion of Control Variables

In equation (4), the variable MAT is included to capture the
impact of term to maturity on yield premium. Empirical evidence
on the relationship between maturity and risk premium,
however, is inconclusive. For example, some studies indicate
that yield premium declines as the length of time to maturity
grows shorter, due to resolution of uncertainty about the default
risk. Other studies argue that yield premium may increase as
maturity approaches due to the increasing probability of default
resulting from the borrower's inability to refinance or redeem
the bond on maturity. This phenomenon has been labeled by
Johnson (1967) as `crisis at maturity.' Hence, the coefficient
related to maturity (MAT) may be positive or negative.
The variable SIZE (par value of the issue outstanding) is
intended to measure the marketability of bond issues. Size as a
measure of marketability has been used by Fisher (1959), Katz
(1974), Billingsley, Lamy, Marr and Thompson (1985) and
Barrett, Heuson and Kolb (1986a and 1986b) in their studies. As
Fisher (1959) indicated, the smaller the amount of bonds a firm
has outstanding, the less frequently its bonds would change
hands, thus the greater the marketability risk and the greater the
risk premium. Therefore, yield premium is expected to be
inversely related to the variable SIZE.
Sinking fund provisions tend to reduce a bond issue's risk
because the provision ensures orderly retirement of bond issues
(Boardman and McEnally, 1981; and Dyl and Joehnk, 1979). So
the sign of the coefficient of sinking fund (SINK) is expected to
be negative.

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346 LIU, SEYYED AND SMITH

Bond indentures typically include call provisions which give the

issuer an option to redeem the outstanding bond after the
expiration of the call deferment period prior to maturity. All
bonds in the sample are callable. Since the call option works to
the advantage of the bond issuer and to the detriment of
investors, call provisions would raise yields on bonds. Three
variables are used in regression equation (4) to capture the call
risk. The first one is the probability of call (PROB CALL,
measured by the ratio of current price to the call price). A bond
is more likely to be called when the prevailing rate of interest is
sufficiently below its coupon rate or alternatively speaking,
premium bonds are more likely to be called than discount or
par value bonds (Jen and Wert, 1967; and Van Horne, 1982),
thus we use the ratio of current price to call price to measure the
probability of call. A higher probability of call should be
associated with a higher yield premium.
Most callable bonds are protected from call until the call
deferment period expires. So the second variable in equation (4)
to capture the call risk is the length of call deferment period
(CALL DEFER). The longer the call deferment period, the lower
the additional yield required by bondholders in compensation
for the call option so we expect the coefficient associated with
this variable has a negative sign. This CALL DEFER will be
assigned a value of zero if the deferment period has expired. The
third call-related variable in equation (4) is the length of the call
option exercise period (CALL EXER PD) ± period from the
expiration of deferment to maturity of the bond, or from the
current time to maturity of the bond if the deferment period has
expired. The longer the exercise period, the greater the value of
the call option is to the bond issuer. The expected coefficient of
this variable is positive.
If a bond indenture provides a lien on a designated property,
the bond is secured. Secured bonds are perceived to be safer
than debentures. Hence, investors require a lower return on
secured bonds relative to comparable unsecured bonds. To
account for the variations in yield premiums due to the security
factor, a dummy variable mortgage (MORT) is included in
equation (4) to distinguish between secured (1) and unsecured
(0) bonds.

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3. DATA AND SAMPLE SELECTION

To test the hypotheses specified above, data were collected on a

sample of corporate bonds. The sample was drawn from the
special edition of Moody's Bond Record of April 26, 1982, through
which the rating refinement was announced. It lists all the
corporate bond issues and indicates both the prior and the
modified rating for each bond. A final sample of 423 corporate
bond issues was obtained after applying the following selection
criteria:

1. Only coupon-bearing, fixed rate, callable corporate bonds

are included to ensure homogeneity of the sample.
2. Since the rating refinements by Moody's only applied to
bonds that were rated Aa to B, the sample is restricted to
issues with ratings in those categories.
3. All issues included in the sample are listed either on the
New York Stock Exchange (NYSE) or American Stock
Exchange (ASE). The primary reason for restricting the
sample to bond issues traded on the NYSE and ASE is to
control for the possibility that dealer quotes on thinly
traded issues might not reflect the true market equilibrium
prices and yields on bonds.
4. Only nonconvertible bonds are included in the sample to
avoid the effect of conversion feature on bond yields.
5. Where a firm has multiple issues listed, one bond which
met the above criteria is randomly chosen.

Table 1 shows the distribution of 423 bonds included in the

final sample by generic and refined rating categories. Of the total
sample, 111 bonds were revised upward and 135 bond issues were
revised downward. There were 177 issues whose ratings were not
revised. The bonds that experienced a rating revision (upward or
downward) constitute the event group, and bonds with unrevised
ratings are used as the control group.
The weekly corporate bond yields for the 22 week period from
13 weeks before to 8 weeks after the announcement of rating
refinement (January 25, 1982 to June 21, 1982) were obtained
from the Media General Data Graphics. Bond specific information
was obtained from the Moody's Bond Record and the Standard &
Poor's Bond Guide.

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Table 1
Distribution of Bonds in the Sample with Ratings Aa to B by Generic
Rating Categories and Refined Rating Categories Assigned by Moody's

Refined Rating Class

Generic 1 2 3 Total %
Rating Class

Aa 20 36 43 99 23.4
A 37 54 35 126 29.8
Baa 25 39 25 89 21.0
Ba 14 20 9 43 10.2
B 15 28 23 66 15.6
Total 111 177 135 423 100.0
% 26.2 41.9 31.9 100.0

To compute the yield premium, samples of Treasury securities

were obtained from the Media General Data Graphics for each week
from January 25, 1982 to June 21, 1982. The sample of Treasury
securities with diverse maturity dates was selected to ensure that a
wide spectrum of the yield curve is covered. `Flower bonds' were
excluded from the sample.13 Also excluded were callable bonds.
The sample of Treasury securities varied over the 22-week period
from 77 issues to 88 issues. The weekly data for the Treasury
bonds was taken from the Media General Data Graphics.

4. EMPIRICAL RESULTS

The regression coefficients and summary statistics of equation

(2) are reported in the Appendix. The Appendix includes the
estimated coefficients and the associated t-statistics for Treasury
security yields as a function of coupon rates, terms to maturity,
and discount from face value as a percentage of the face value for
each of the 22 weeks from t ˆ ÿ8 to t ˆ ‡13. Table 2 presents
the average differential yield premiums (ADYP) for the combined
sample (of a short portfolio in upward revised bonds and a long
portfolio in downward revised bonds) over the test period from
13 weeks before …t ˆ ÿ13† to 8 weeks after …t ˆ ‡8† the
announcement of rating refinement. The results indicate that
the average differential yields premiums (ADYP) are positive and

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Table 2
Average Differential Yield Premiums (ADYP), Standard Deviations and
t-Statistics for Combined Sample of Upward and Downward Revised
Bonds (N = 246) Surrounding the Announcement Day of Moody's
Rating Refinement From 13 Weeks Before to 8 Weeks After the
Announcement

Week Relative ADYP Standard

to Change (%) Deviation t-value
(%)

ÿ13 0.151 1.130 2.096*

ÿ12 0.171 1.245 2.154*
ÿ11 0.178 1.207 2.313*
ÿ10 0.183 1.154 2.487**
ÿ9 0.197 1.114 2.774***
ÿ8 0.150 1.138 2.067*
ÿ7 0.220 1.170 2.949***
ÿ6 0.220 1.325 2.604***
ÿ5 0.204 1.325 2.415*
ÿ4 0.218 1.298 2.634***
ÿ3 0.286 1.401 3.202***
ÿ2 0.296 1.343 3.457***
ÿ1 0.242 1.250 3.037***
0 0.254 1.270 3.137***
1 0.263 1.285 3.210***
2 0.258 1.149 3.522***
3 0.273 1.194 3.586***
4 0.267 1.183 3.540***
5 0.280 1.298 3.383***
6 0.282 1.244 3.556***
7 0.328 1.279 4.022***
8 0.267 1.195 3.504***
Notes:
* Significant at the 0.05 confidence level of a one-tailed t-test.
** Significant at the 0.01 confidence level of a one-tailed t-test.
*** Significant at the 0.005 confidence level of a one-tailed t-test.

significantly different from zero for the entire test period. The
evidence of significant ADYPs prior to the rating refinement
announcement suggest that the market has already made a
distinction between upward and downward revised bonds. Given
the positive ADYPs before the announcement, we further
examine whether the difference in the yield premiums between
event group bonds and benchmark bonds manifests any
significant increase after the announcement. The evidence of a
significant increase in the ADYP following the announcement

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350 LIU, SEYYED AND SMITH

would indicate that rating refinements by Moody's provided new

information to the market. Otherwise, the evidence would
suggest that the market had already completely segmented
bonds into subclasses and the announcements of rating
refinement provided no additional information to the market.
To test whether the ADYP significantly increases after the
announcement of rating refinement, the differential yield
premiums for bonds whose ratings are revised are averaged
across 13 weeks before …t ˆ ÿ13 to t ˆ ÿ1† and 9 weeks after …t ˆ 0
to t ˆ ‡8† the announcement. Next, the difference in means test
is performed to determine if the pre- and post-announcement
ADYPs are significantly different. The results of the analysis are
presented in Table 3. The results show that the average
differential yield premium during the 13 weeks before the rating
refinement announcements is 20.9 basis points and the average
differential yield premium during the nine weeks after the rating
refinement announcements is 27.5 basis points. The difference is
statistically significantly different from zero at the 0.05
confidence level for a one-tailed t-test.
Previous studies by Griffin and Sanvicente (1982), Hand, Holt-
hausen and Leftwich (1992), Holthausen and Leftwich (1986) and
Matolcsy and Lianto (1995) show that reclassification of bonds
across rating categories that lead to downgrading have a greater

Table 3
Comparison of Average Differential Yield Premium (ADYP) Between
the Pre- and Post-Announcement of Moody's Rating Refinement for the
Combined Sample of Upward and Downward Revised Bonds (N = 246).
The ADYP for the 13 Weeks Before the Announcement (t ˆ ÿ13 to
t ˆ ÿ1) are Compared with the ADYP for the Nine Weeks After the
Announcement (t ˆ 0 to t ˆ ‡8)

Weeks Standard Pooled

Relative ADYP Deviation Sample t-value
to Change (%) (%) Size

t ˆ ÿ13 to t ˆ ÿ1 0.209 1.240 3198

1.920*
t = 0 to t = 8 0.275 1.232 2214

Notes:
* Significant at the 0.05 confidence level of a one-tailed t-test.

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impact on stock prices than upgrading of bonds. The greater

impact of downgrading may be due to the fact that management
has an incentive to quickly disseminate favorable information
which may potentially lead to upgrading while withholding any
unfavorable information which may result in downgrading. As
such, the market may have already adjusted to the favorable
information that eventually leads to upgrading. The downgrading
of bond issues, on the other hand, may provide new information to
the market and hence has greater impact on security prices.

Table 4
Average Differential Yield Premiums (ADYP), Standard Deviations, and
t-Statistics for Upward Revised Bonds (N = 111) Surrounding the
Announcement of Moody's Rating Refinement from 13 Weeks Before
(t ˆ ÿ13) to 8 Weeks After (t = 8)the Announcement

Week Standard
Relative to ADYP Deviation t-value
Change (%) (%)

ÿ13 ÿ0.216 1.049 ÿ2.161***

ÿ12 ÿ0.205 1.244 ÿ1.736*
ÿ11 ÿ0.190 1.212 ÿ1.650*
ÿ10 ÿ0.186 1.056 ÿ1.855*
ÿ9 ÿ0.190 1.021 ÿ1.956*
ÿ8 ÿ0.192 1.010 ÿ1.997*
ÿ7 ÿ0.193 1.075 ÿ1.894*
ÿ6 ÿ0.200 1.185 ÿ1.785*
ÿ5 ÿ0.187 1.144 ÿ1.487
ÿ4 ÿ0.227 0.976 ÿ2.437**
ÿ3 ÿ0.214 1.093 ÿ2.057*
ÿ2 ÿ0.275 1.143 ÿ2.549**
ÿ1 ÿ0.208 1.039 ÿ2.103*
0 ÿ0.210 1.080 ÿ2.054*
1 ÿ0.245 1.076 ÿ2.405**
2 ÿ0.225 1.003 ÿ2.364**
3 ÿ0.234 1.439 ÿ2.109*
4 ÿ0.197 1.146 ÿ1.803*
5 ÿ0.239 1.346 ÿ1.863*
6 ÿ0.342 1.308 ÿ2.761***
7 ÿ0.310 1.242 ÿ2.630***
8 ÿ0.244 1.116 ÿ2.301*
Notes:
* Significant at the 0.05 confidence level of a one-tailed t-test.
** Significant at the 0.01 confidence level of a one-tailed t-test.
*** Significant at the 0.005 confidence level of a one-tailed t-test.

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352 LIU, SEYYED AND SMITH

To gain additional insights regarding the impact of rating

refinements on bond yields, we further separately examine the
behavior of average differential yield premiums for upward
revised bonds and downward revised bonds. Table 4 and Table 5
present the average differential yield premiums for upward and
downward revised bonds, respectively. The average differential
yield premiums for upward revised bonds are consistently
negative and significantly different from zero throughout the
test period …t ˆ ÿ13 to t ˆ ‡8† surrounding the announcement

Table 5
Average Differential Yield Premiums (ADYP), Standard Deviations, and
t-Statistics for Downward Revised Bonds (N = 135) Surrounding the
Announcement of Moody's Rating Refinement from 13 Weeks Before
(t ˆ ÿ13) to 8 Weeks (t = 8) After the Announcement

Week Standard
Relative to ADYP Deviation t-value
Change (%) (%)

ÿ13 0.098 1.193 0.951

ÿ12 0.143 1.250 1.325
ÿ11 0.169 1.207 1.622
ÿ10 0.180 1.232 1.699*
ÿ9 0.203 1.189 2.000*
ÿ8 0.116 1.236 1.090
ÿ7 0.243 1.247 2.268*
ÿ6 0.236 1.435 1.903*
ÿ5 0.217 1.462 1.721*
ÿ4 0.211 1.517 1.611
ÿ3 0.345 1.613 2.483**
ÿ2 0.313 1.492 2.443**
ÿ1 0.270 1.403 2.234*
0 0.291 1.411 2.405**
1 0.277 1.439 2.236*
2 0.286 1.259 2.651***
3 0.305 1.010 2.909***
4 0.325 1.213 3.121***
5 0.313 1.262 2.875***
6 0.232 1.192 2.253**
7 0.343 1.313 3.032***
8 0.286 1.261 2.620***
Notes:
* Significant at the 0.05 confidence level of a one-tailed t-test.
** Significant at the 0.01 confidence level of a one-tailed t-test.
*** Significant at the 0.005 confidence level of a one-tailed t-test.

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of rating refinement. Similarly, the average differential yield

premiums for downward revised bonds are uniformly positive
throughout the test period and significantly different from zero
for most of the test period around the announcement of rating
refinement.
To evaluate the impact of rating refinements on bond yields,
following the procedure outlined earlier, the differential yield
premiums were averaged across 13 weeks prior to the announce-
ment and nine weeks after the announcement separately for
upward revised and downward revised bonds. Next, the
difference in means tests were performed to ascertain the impact
of upward and downward revision individually. The results of the
analysis are presented in Tables 6 and 7 respectively.
Table 6 shows the results of the difference in means tests for
upward revised bonds. The results indicate that the ADYPs
during the 13 weeks before the rating refinement announcement
is ÿ20.6 basis points and the ADYPs during the nine weeks after
the announcement is ÿ24.9 basis points. Although the move-
ment is in the hypothesized direction, the differences are not
statistically significantly different from each other at the 0.05
confidence level.
However, the results of difference in means test for downward
revised bonds are different and statistically significant. The

Table 6
Comparison of Average Differential Yield Premiums (ADYP) Between
the Pre- and Post-Announcement of Moody's Rating Refinement for the
Upward Revised Bonds (N = 135). The ADYP for the 13 Weeks Before
the Announcement (t ˆ ÿ13 to N ˆ ÿ1) are Compared with the ADYP
for the Nine Weeks After the Announcement (t = 0 to t = +8).

Weeks Standard Pooled

Relative to ADYP Deviation Sample t-value
Change (%) (%) Size

Panel A
t ˆ ÿ13 to t ˆ ÿ1 ÿ0.206 1.094 1443
ÿ0.920n.s.
t = 0 to t = 8 ÿ0.249 1.166 999
Notes:
n.s. Not significant at the 0.05 confidence level.

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354 LIU, SEYYED AND SMITH

Table 7
Comparison of Average Differential Yield Premiums (ADYP) Between
the Pre- and Post-Announcement of Moody's Rating Refinement for the
Downward Revised Bonds (n = 111). The ADYP for the 13 Weeks Before
the Announcement (t ˆ ÿ13 to t ˆ ÿ1) are Compared with the ADYP
for the nine Weeks After the Announcement (t = 0 to t = +8).

Weeks Standard Pooled

Relative to ADYP Deviation Sample t-value
Change (%) (%) Size

Panel A
t ˆ ÿ13 to t ˆ ÿ1 0.211 1.349 1755
1.710*
t = 0 to t = 8 0.295 1.284 1215
Notes:
* Significant at the 0.05 confidence level of one-tailed t-test.

results are presented in Table 7. The results in Table 7 show that

the ADYPs during the 13 weeks before the rating refinement
announcement is 21.1 basis points and the ADYPs during the
nine weeks after the announcement is 29.5 basis points, and they
are significantly different from each other at the 0.05 confidence
level of a one-tailed test. The results in Tables 6 and 7 suggest the
reaction of the prices of the combined portfolio is mainly caused
by the bonds whose ratings are revised downward. The results are
also consistent with previous studies that downgrading of bond
issues tends to have greater impact on security prices than
upgrading.

5. CONCLUSION

In summary, the overall evidence presented in this paper

indicates that the bond market responds to the announcement
of downward revision of Moody's rating refinement. The findings
in the paper, in addition to confirming the results in previous
studies that downgrading tends to have greater impact on
security prices than upgrading, have several implications.
First, rating refinement is not caused by the change in the
issuer's financial positions. Instead, it is only an action taken by
Moody's to change from one rating system to another. As a result,

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 IMPACT OF CREDIT RATING CHANGES 355

the findings in the paper suggest that rating agencies do have an

independent impact on bond prices ± a concept first suggested by
West (1973), and later empirically confirmed by Liu and Thakor
(1984) in the municipal bond market.
Second, the magnitude of rating revisions caused by
refinement is very minimal ± only one third of one generic
rating category, and all ratings are revised within the bonds'
original rating categories, as opposed to across rating categories.
Given the findings in the literature (e.g. Holthausen and
Leftwich, 1986) that within rating changes tend to have smaller
effects on security prices than across rating changes, we may
expect the information content to be stronger for rating changes
which are greater than the minimal magnitude and when they
are made across rating categories.
Thirdly, studies in the literature have reported that rating
agencies are information producers which have the expertise to
generate information that is not publicly available (e.g.
Ederington, Yawitz and Roberts, 1987), and therefore revisions
in credit rating contain incremental information to the financial
market (e.g. see Matolcsy and Lianto, 1995). The results in our
paper appear to support these findings.
The findings in this study also have implications for future
studies. For instance, in recent years the number of downgrades
in corporate bond ratings has exceeded the number of upgrades
in the US. This result has led some to conclude that the credit
quality of US corporate bonds has declined in recent years.
However, in a recent paper Blume, Lim and MacKinlay (1998)
indicate that an alternative explanation to this apparent decline
in credit quality may be that the rating agencies in the US are
using more stringent standards in assigning ratings, and their
study confirmed the alternative explanation. If credit ratings do
have an independent impact on security, and if rating agencies are
now using more stringent standards in assigning ratings, then we
may expect that recent upgrades in bond ratings have a greater
impact on security prices than the upgrades in earlier years since it
is more difficult for a corporate bond to receive a rating upgrade
recently than in earlier days. By the same token, the negative
impact of a recent downgrade may not be as serious as a
downgrade in earlier years due to the fact that the standards
which rating agencies are using are more stringent now than in

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356 LIU, SEYYED AND SMITH

earlier years. Future studies may examine these hypotheses by

studying the price impact of upgrades and downgrades in recent
years versus earlier years.
Furthermore, recent currency crises in Asia have led rating
agencies to downgrade the sovereign bonds issued by the Asian
governments. If credit ratings have an independent impact on
security prices, then we may expect that the downgrades still have
an impact on bond prices even though the currency crises have
been repeatedly reported in the press. To the best of our
knowledge, the impact of rating downgrades on sovereign bonds
in the midst of Asian currency crises has not been thoroughly
examined in the bond literature and it would be an interesting
topic to study.

APPENDIX
The regression coefficients and summary of statistics of treasury securities yields
as a function of coupon rates, terms to maturity (measured in natural logarithm
of months), and discount from the face value divided by the face value
(equation (2)) for each of the 22 weeks from January 25, 1982 (13 weeks before
the announcement of the rating refinement) to June 21, 1982 (eight weeks
after the announcement). Values in parenthesis are t-values associated with
regression coefficients and asterisks indicate a significance level at 1%.

Weeks Y = a + b1CR + b2LMAT + b3DISC

Jan. 25 Y = 13.83 + 0.091CR ÿ 0.077LMAT + 0.007DISC

t ˆ ÿ13 (8.43) (ÿ2.26) (1.80)
R-Square = 0.7192
Model F-Value = 67.43*
N = 83

Feb. 01 Y = 13.44 + 0.057CR ÿ 0.004LMAT + 0.0003DISC

t ˆ ÿ12 (6.71) (ÿ0.17) (0.13)
R-Square = 0.7155
Model F-Value = 62.04*
N = 78

Feb. 08 Y = 14.14 + 0.075CR ÿ 0.132LMAT + 0.005DISC

t ˆ ÿ11 (9.48) (ÿ6.44) (1.79)
R-Square = 0.7887
Model F-Value = 95.80*
N = 81

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Weeks Y = a + b1CR + b2LMAT + b3DISC

Feb. 15 Y = 15.07 + 0.069CR ÿ 0.396LMAT ÿ 0.001DISC

t ˆ ÿ10 (8.23) (ÿ18.3) (ÿ0.42)
R-Square = 0.9133
Model F-Value = 291.29*
N = 87

Feb. 22 Y = 15.07 + 0.069CR ÿ 0.396LMAT ÿ 0.001DISC

t ˆ ÿ9 (8.23) ÿ18.3) (ÿ0.42)
R-Square = 0.9133
Model F-Value = 291.29*
N = 87

Mar. 01 Y = 13.15 + 0.089CR ÿ 0.081LMAT + 0.007DISC

t ˆ ÿ8 (8.65) (ÿ3.25) (2.01)
R-Square = 0.7423
Model F-Value = 70.08*
N = 77

Mar. 08 Y = 12.71 + 0.060CR + 0.006LMAT ÿ 0.003DISC

t ˆ ÿ7 (7.57) (0.33) (ÿ0.97)
R-Square = 0.7745
Model F-Value = 90.45*
N = 83

Mar. 15 Y = 12.72 + 0.077CR + 0.030LMAT + 0.002DISC

t ˆ ÿ6 (7.64) (ÿ1.24) (0.71)
R-Square = 0.7052
Model F-Value = 59.81*
N = 79

Mar. 22 Y = 13.67 + 0.061CR ÿ 0.137LMAT + 0.0008DISC

t ˆ ÿ5 (7.66) (ÿ7.48) (0.29)
R-Square = 0.7935
Model F-Value = 97.36*
N = 80

Mar. 29 Y = 13.39 + 0.059CR ÿ 0.033LMAT ÿ 0.004DISC

t ˆ ÿ4 (5.98) (ÿ1.31) (ÿ1.16)
R-Square = 0.7068
Model F-Value = 60.26*
N = 79

Apr. 05 Y = 13.70 + 0.065CR ÿ 0.106LMAT ÿ 0.002DISC

t ˆ ÿ3 (7.12) (ÿ5.00) (ÿ0.51)
R-Square = 0.7638
Model F-Value = 88.38*
N = 86

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358 LIU, SEYYED AND SMITH

Weeks Y = a + b1CR + b2LMAT + b3DISC

Apr. 12 Y = 13.87 + 0.058CR ÿ 0.119LMAT ÿ 0.002DISC

t ˆ ÿ2 (7.28) (ÿ6.34) (ÿ0.79)
R-Square = 0.8174
Model F-Value = 117.86*
N = 83

Apr. 19 Y = 13.90 + 0.065CR ÿ 0.241LMAT ÿ 0.003DISC

t ˆ ÿ1 (5.96) (ÿ10.88) (ÿ0.73)
R-Square = 0.8255
Model F-Value = 132.45*
N = 88

Apr. 26 Y = 13.46 + 0.065CR ÿ 0.144LMAT ÿ 0.004DISC

t=0 (6.33) (ÿ6.22) (ÿ1.05)
R-Square = 0.7905
Model F-Value = 95.60*
N = 80

May. 03 Y = 13.10 + 0.054CR ÿ 0.008LMAT ÿ 0.006DISC

t = +1 (5.96) (ÿ0.41) (ÿ1.92)
R-Square = 0.7625
Model F-Value = 82.39*
N = 81

May. 10 Y = 13.00 + 0.047CR ÿ 0.023LMAT ÿ 0.009DISC

t = +2 (5.13) (ÿ1.19) (ÿ2.93)
R-Square = 0.7857
Model F-Value = 95.32*
N = 82

May. 17 Y = 13.01 + 0.059CR ÿ 0.063LMAT ÿ 0.008DISC

t = +3 (5.01) (ÿ2.48) (ÿ1.86)
R-Square = 0.7195
Model F-Value = 66.70*
N = 82

May. 24 Y = 11.89 + 0.060CR + 0.192LMAT ÿ 0.010DISC

t = +4 (5.26) (7.31) (ÿ2.27)
R-Square = 0.7273
Model F-Value = 70.22*
N = 83

May. 31 Y = 11.76 + 0.044CR ÿ 0.320LMAT + 0.010DISC

t = +5 (3.11) (1.11) (ÿ1.68)
R-Square = 0.7455
Model F-Value = 79.09*
N = 85

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Weeks Y = a + b1CR + b2LMAT + b3DISC

Jun. 07 Y = 12.34 + 0.064CR + 0.178LMAT ÿ 0.007DISC

t = +6 (5.86) (7.37) (ÿ1.84)
R-Square = 0.7576
Model F-Value = 83.33*
N = 84

Jun. 14 Y = 12.58 + 0.056CR + 0.149LMAT ÿ 0.012DISC

t = +7 (4.69) (5.74) (ÿ3.15)
R-Square = 0.7394
Model F-Value = 72.82*
N = 81

Jun. 21 Y = 13.90 + 0.041CR ÿ 0.057LMAT ÿ 0.017DISC

t = +8 (3.58) (2.03) (ÿ4.12)
R-Square = 0.7630
Model F-Value = 80.49*
N = 79

NOTES
1 Besides Moody's and Standard & Poor's, the third main rating agency is
Fitch Investors Service. Fitch rates fewer firms than Moody's and Standard &
Poor's, but enjoys a special clout in rating of banks. In fact, rating of banks is
reported to be its major business. A more recent entrant in the bond rating
business is Duff and Phelps, which is primarily involved in rating utility
bonds since 1980.
2 For example, the Banking Act of 1933 prohibited federally chartered banks
from holding `speculative bonds' ± bonds having ratings lower than Baa3 ±
in their asset portfolios. They can hold only `investment grade' bonds ±
bonds having ratings of Baa3 or better. Many states also have similar `Blue
Sky' laws which allow financial institutions to hold only high quality bonds.
3 Examples of recent studies in bond ratings include Blume, Lim and
MacKinlay (1998), Cantor and Packer (1994 and 1995), Goh and
Ederington (1993), Hand, Holthausan and Leftwich (1992), and Jewell
and Livingston (1998). Earlier studies in bond ratings include Holthausan
and Leftwich (1986), Liu and Thakor (1984), Liu and Moore (1987), Perry,
Liu and Evans (1988) among other papers listed in the Reference list.
4 Early studies examining the association of ratings and ex post default
experience of bonds include Hickman (1958) and Atkinson (1967). More
recently, the association between bond ratings and default experience was
extensively examined again. Examples of these studies include Altman
(1989 and 1992), and Altman and Kao (1992a and 1992b).
5 West (1973) first made this argument, to the best of our knowledge.
6 Stickel (1986, p. 198, footnote 2) uses the following example to illustrate
how the claims of causality between changes in yields (or prices) and
changes in bonds ratings solely based on the correlation between them may
be a mistake.
For example, on 8/1/79 the Wall Street Journal reported a Chrysler earnings
announcement. The return to Chrysler preferred stock was approximately ÿ3% on

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360 LIU, SEYYED AND SMITH

7/31/79 and ÿ11% on 8/1/79. Moody's downgraded the rating of Chrysler

preferred stock on 7/31/79 and Standard & Poor's downgraded Chrysler on 8/1/
79. Although the issue of causality cannot be conclusively resolved, it would be a
mistake to assume the rating change caused the decline in preferred stock price. It
is possible the earnings announcement caused both the decline in preferred stock
price and the rating change.
7 Standard & Poor's refined its ratings in 1974 by adding `+' (plus) and `ÿ'
(minus) to each generic rating category from `AA' to `B' to indicate whether
a bond is ranked at high end or low end of a rating category. After Moody's
adopted the refined rating system in 1982, there is a one-to-one
correspondence between Standard & Poor's and Moody's rating systems.
The following table lists the comparison of Standard & Poor's and Moody's
refined rating categories:

Standard & Poor's Moody's

AAA Aaa
AA+ Aa1
AA Aa2
AAÿ Aa3
A+ A1
A A2
Aÿ A3
BBB+ Baa1
BBB Baa2
BBBÿ Baa3
BB+ Ba1
BB Ba2
BBÿ Ba3
B+ B1
B B2
Bÿ B3
CCC Caa
CC Ca
C C
D n/a

8 See Alexander (1980) for a detailed discussion of the problems in applying

the market model to long-term corporate bonds. The results show that the
assumption of normality of residuals, homoskedasticity, and absence of
serial correlation are seriously violated when the market is defined as the
bond index. The bond betas appear to be sensitive to the index employed
and time period used. Thus, the use of market model to analyze bonds
involves violations of the underlying assumptions of the regression and
parameter instability.
9 The return on bonds comprises of two ingredients: interest income and
capital gains. The favorable tax treatment of capital gains relative to interest
income during the sample period makes discount bonds more attractive to
investors than similar premium bonds. Consequently, the yields on discount
bonds are lower than comparable nondiscount bonds. Empirical studies
confirm that yields are lower on discount bonds than similar par or

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 IMPACT OF CREDIT RATING CHANGES 361
premium bonds. These studies include Shiller and Modigliani (1979), and
Van Horne (1982).
10 In order to reaffirm that the model specified in equations (1) and (2) are
appropriate, we also estimate Treasury yield as a function of DISCTt
(discount from the face value divided by the face value), and the duration
(DURA) of the Treasury bond for the three weeks surrounding the
announcement of the refinement. The duration for each Treasury bond was
calculated according to the formula developed by Caks, Lane, Greenleaf
and Joules (1985). The R2 based on DISCTt and DURA are not as good as
equation (2). The results indicate that equations (1) and (2) are
appropriate. The results of the regression based on DISCTt and DURA for
the three weeks surrounding the announcement of refinement (April 19,
April 26, and May 3, 1982 respectively) are summarized as follows: (numbers
in parentheses are t-statistics):
April 19 Y = 14.06 ÿ 0.0218DISC ÿ 0.0407DURA R2 = 0.7288
(ÿ10.02) (ÿ8.97)
April 26 Y = 13.89 ÿ 0.0201DISC ÿ 0.0271DURA R2 = 0.7125
(ÿ10.93) (ÿ6.99)
May 3 Y = 13.99 ÿ 0.0193DISC ÿ 0.0166DURA R2 = 0.7288
(ÿ12.46) (ÿ5.03)
11 For example, Dyl and Joehnk (1979) find that the effect of sinking fund
provision is less important for higher-grade bonds than for medium-grade
issues. Similarly, the impact of maturity on yield premium may not be
uniform across rating categories due to the `crisis at maturity' phenomena
as noted by Johnson (1967). Likewise, security is more important for bonds
in the lower rating categories than bonds in the higher ratings.
12 Jaffee (1974), Weinstein (1977), Masulis (1980) and Stickel (1986) have
used this approach of combining two portfolios that respond to information
announcements in opposite directions. Jaffee examines the impact of
insiders' buying and selling on stock prices. Weinstein (1977) and Stickel
(1986) study the effect of upgrading and downgrading of ratings on security
prices, and Masulis (1980) investigates the effect of increase and decrease of
debt ratios on security returns.
13 Flower bonds are Treasury bonds that can be used at their face value to pay
estate taxes. These bonds carry very low coupon rates and therefore
generally sell for a substantial discount from their face value. Because the
yields on Flower bonds also reflect estate tax benefits, we do not include
Flower bonds in our sample.

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