The Effect of Seniority and Security Covenants on Bond Price Reactions to Credit News

Abstract:     
We examine the daily abnormal returns of corporate bonds with different seniority and security covenants following Moody's Watchlist and rating change events. We find that bond returns react significantly positive (negative) following upgrade (downgrade) Watchlist events but not necessarily following rating change events. Because Watchlist news precede rating changes, we infer that the Watchlist contains more unexpected information and, hence, the short-run bond price effects are stronger. We also find that subordinated bond prices react more than secured bonds to Watchlist news. However, this finding does not hold when we compare investment and non-investment grade bonds, suggesting that seniority/security can explain the cross sectional bond returns. Our regression results confirm this finding even after controlling for issue- and issuer-specific characteristics such as time to maturity, coupon rate, bond rating, and firm size.

Keywords: Corporate bonds, Seniority/Security, TRACE, Watchlist

JEL Classifications: G20, G24, G14, G33

Working Paper Series