Journalof

BANKING &
FINANCE
ELSEVIER Journal of Banking & Finance 19 (1995) 891-902

The incremental information content of bond

rating revisions: The Australian evidence
Z.P. Matolcsy a,*, T. Lianto b
a School of Accounting, University of Technology, PO Box 123, Broadway, Sydney, NSW 2007
Australia
bAMP Society Sydney, NSWAustralia

Received September 1992; final version received July 1993

Abstract

The objective of this study is to provide evidence on the information content of bond
revisions by controlling for the information content of concurrent annual accounting income
numbers and testing the incremental information content of bond rating revision. The
reasons for this approach is threefold. First, the information content of annual accounting
income numbers is well documented in the literature. Second, bond rating agencies in their
revisions extensively utilise accounting information, hence it could be argued that bond
rating revisions only confirm what is already known by equity investors. Third, recent
evidence indicates an 'earnings drift' effect surrounding earnings announcements which
could drive abnormal returns associated with bond revisions. However, by controlling for
the information content of annual accounting income numbers, evidence can be provided on
the value added by rating agencies. The results of the study indicate that only the
announcement of bond downgrades has incremental information content.

Keywords: Bond revisions; Information content; Market reaction

JEL classification: G30

* Corresponding author. P.O. Box 123, Broadway, NSW 2007, Australia.

0378-4266/95/$09.50 © 1995 Elsevier Science B.V. All rights reserved

SSDI 0378-4266(94)00082-4
892 z.P. Matolcsy, T. Lianto /Journal of Banking & Finance 19 (1995) 891-902

I. I n t r o d u c t i o n

To date, a number of studies have addressed the information content of bond

rating revisions by measuring the abnormal returns of common stocks around the
announcement date of bond rating revisions. The studies of Pinches and Singleton
(1978) and Wakeman (1978) using monthly rates of return find little support for
the information content of bond rating revisions. On the other hand, Holthausen
and Leftwich (1986) analyse the information content of 1,014 bond rating revi-
sions over the period of 1977-1982 by estimating daily abnormal stock returns.
Their study provides weak support for the information content of sub-groups of
bond downgrades and no support for the information content of bond upgrades.
Similar findings are reported by Hand et al. (1992).
Cornell et al. (1989) provide a conceptual framework for the information
content of rating revisions. They argue that revisions in bond ratings may have an
information content because they reflect a more informed estimate of the intangi-
ble assets of a firm and the implicit claims on an entity by other stakeholders such
as employees and suppliers. Accordingly, their experiment aims to explain daily
raw returns surrounding the announcement of bond rating revisions in terms of
different estimates of scaled intangible assets, 1 the number of grades the rating
was changed and the investment grade of the rating revisions. The results of their
study provides weak support for the explanatory power of the scaled intangible
assets in the case of downgrades, but it does not support the explanatory power of
any other variables for downgrades or upgrades. In summary, the evidence to date
on the information content of bond revisions is conflicting, although there is s o m e
tentative support for the information content of bond downgrades.
The objective of this study is to provide further evidence on this issue by
controlling for the information content of concurrent annual accounting income
numbers and providing evidence on the incremental information content of bond
revisions. 2 The reasons for this approach is threefold. First, the information
content of annual accounting income numbers is well documented in the literature. 3
Second, bond rating agencies in their revisions extensively utilise accounting
information, amongst other qualitative/quantitative information, hence it could be
argued that bond revisions only confirm what is already known by equity
investors. However, by controlling for the information content of annual account-
ing income numbers, evidence can be provided on the value added by rating
agencies to the existing information set. Third, a number of recent studies reported
some market anomalies with respect to an 'earnings drift' effect 60 days

I Intangibleassets were scaled by the numberof grades by which ratings were changed.
2 Jennings (1990) provides an explanationand interpretation of incremental information content.
3 See, for example, Foster (1986) for a summaryof the international evidence on this.
 Z.P. Matolcsy, T. Lianto /Journal of Banking & Finance 19 (1995) 891-902 893

before/after the earnings announcements. 4 Hence abnormal returns surrounding

the announcement of bond revisions could be still driven by expected a n d / o r
previous earnings announcements. Finally, one advantage of this study is that it
utilises non-US data to provide evidence on the information content of rating
revisions and accordingly it will provide an international comparison for the US
results.
The remainder of this paper is organised as follows. In the next section some
conceptual/experimental issues are identified, the following section details the
experimental design. In the fourth section the results are reported and the last
section summarises the implications of the findings.

2. Conceptual/experimental issues that pervade previous studies

There are at least two conceptual and experimental issues which need to be
addressed before the formal hypothesis can be formulated and the appropriate
experimental design be developed.

2.1. The conceptual linkage between bond re-ratings and stock returns

One of the inherent difficulties in developing the testable implications of the

impact of bond rating revision on stock returns is that there is not an established
theoretical framework to explain this linkage. Finance theory provide an insight
into the conflict of interest between stockholders and bondholders and the con-
tracting theory explains the resolution of this conflict in terms of the negotiated
trust deed. 5 Within the contracting theory framework bond ratings may have a
useful role to play in determining the type of positive/negative pledges which are
part of the trust deed for new bonds. However, neither finance theory nor
contracting theory provides any insight into the effect of the revision of the risk of
an existing bond issue on expected risk and return characteristics of a stocks.
The conceptual framework developed by Cornell et al. (1989) also fails to
provide such a linkage as they assume that the revision of the risk of an existing
debt instrument would impact only on expected stock returns but not on the risk of
a stock.
Accordingly, capital market theory is the only established theoretical frame-
work within which the value added by rating agencies can be tested. In this
framework, market efficiency is assumed and the information content of rating
revision announcements can be tested. However, in this framework, there is a need
to control for the impact of other announcement effects or confounding effects.

4 See, for example,Foster et al. (1984) and Bernardand Thomas (1989).

5 Watts and Zimmerman(1986) providean overviewof this literaturein their book.
894 z.P. Matolcsy, T. Lianto/Journal of Banking & Finance 19 (1995) 891-902

2.2. The information content of bond rating revisions and confounding effects

The problem of confounding effect has long been recognised in the literature
when testing the information content of other announcements. 6 However, earlier
studies on the announcement effect of bond rating revisions ignore confounding
effects. The more recent studies by Holthausen and Leftwich (1986) and Hand et
al. (1992) recognised this problem and aim to control for it by evaluating the
information content of bond revisions within a narrow window of a few days
surrounding the announcement. However, this procedure still does not eliminate
the possibility that the abnormal returns are driven by the impact of the unex-
pected accounting income numbers alone due to the earnings drift effect, rather
than the value added by rating agencies. The study by Cornell et al. (1989) also
ignores the problem of confounding effects.
This study explicitly recognises the information content of unexpected account-
ing income numbers and will test for the value added by agencies by testing for
the incremental effect of bond revisions.
Formally, maintaining the null hypothesis of zero information content of bond
rating revisions, the following two alternative hypotheses are tested:
H 1 the joint information content of unexpected accounting income numbers and
bond rating revision is non-zero (the joint information content hypothesis);
H 2 the information content of bond rating revisions beyond the information
content of annual income numbers is non-zero; (incremental information
content hypothesis).

3. T h e e x p e r i m e n t a l design

3.1. Sample and data

The bond revisions were based on the ratings of S &P - Australian Ratings.
The rating agency, Australian Ratings, was established in 1981 and according to
the international eomparision by Foster (1986, p. 499) it is comparable in terms of
size and methodology to other agencies, with the exception of the two 'big ones';
Standard and Poor's and Moody's. Australian Ratings was acquired by Standard
and Poor's in March 1990. Since that date, the rating agency has been trading as
S & P - Australian Ratings.
Collecting the observations on bond revisions, the following selection criteria
have been adopted:
(i) Firms whose bonds have been revised, had to be listed on the Australian

6 See for example evidence on the incremental information contents of alternative measures of
operating income, Lobo and Song (1989) and on selected items for financial statements by Castagna
and Matolcsy (1989).
 Z.P. Matolcsy, T. Lianto /Journal of Banking & Finance 19 (1995) 891-902 895

Associated Stock Exchanges at least seventeen weeks prior and seventeen

weeks after the rating revision;
(ii) rating revisions had to be reported in the S & P - Australian Ratings Monthly
Bulletin, and finally
(iii) firms with rating revisions were not subject to adverse situations such as
takeovers, mergers, corporate restructuring or suspension from listing.
Sixty-two different public listed companies from the Monthly Bulletin of S & P
- Australian Ratings satisfied the above selection criterion during the period of
1982-1991. A number of companies' debt instruments have been revised more
than once, leading to a total sample of 34 rating upgrades and 38 rating
downgrades. 7 Most of the grade changes were consecutive levels of upgrades and
downgrades, in fact only 8 revisions represented more than a change of two
grades. This limited number of 'grading jumps' will not enable the study to
contrast the difference between minor and substantial bond revisions.
Weekly rates of return for each of the sample companies were based on the
adjusted share prices from the Pont-Advantage and Equity-Net on line data bases
for a period of 17 weeks before and 17 weeks after the announcement of the bond
revision, s Adjusted annual earnings per share (EPS) estimates were collected from
the Sydney Stock Exchange Statex data base for each of the sample companies for
the years surrounding the announcement of the bond revision.

3.2. Methodology
To provide evidence on the joint information content of bond revisions and
accounting income numbers, the following steps were undertaken. First, a 'martin-
gale model was used to estimate the unexpected component of accounting income
numbers to get an insight into the relationship between upgrades (downgrades) and
unexpected positive (negative) accounting income numbers on the basis of the
evidence by Finn and Whittred (1982):
AEPS = Y i , t - E t ( Y i , t _ l ) (1)
Where
AEPS = unexpected component of accounting income number
E, = expectation at time t
Y/,t = EPS for firm i at time t
Y/,t-1 = EPS for firm i at time t - 1

7 The names of companies are available from the authors on request.

s Weekly rather than daily data was used as the actual day in the middle of the month when the
Monthly Bulletin is released cannot be exactly identified. The Bulletin is mailed out to subscribers in
the middle of each month and the financial press may report some of the changes. Reporting dates have
been identified by the Infoline Service whilst the date of the receipt of the Monthly Bulletins were
provided by one of the largest financial institutions. We identified the announcement week by the
earliest of these two dates.
896 Z.P. Matolcsy, T. Lianto /Journal of Banking & Finance 19 (1995) 891-902

Second, the joint information content of bond revision and accounting income
numbers were measured by the prediction errors (PE) of the zero-one version of
the market model: 9

PEit = Rit - Rmt (2)

Where
Ri, t =weekly rate of return on the common stock i at time t,
Rm,t = weekly market rate o f return measured by the All Ordinaries
Accumulation Index at time t.

Finally, the prediction errors were averaged across firms with upgrades and
firms with downgrades and accumulated over a period of seventeen weeks prior
and seventeen weeks after the announcement of the bond revision to derive the
cumulative predictive error (CPE):
1 ~v
CPE, = ~ EPE,,, (3)
i=l
To test whether the cumulative predictive errors (CPE's) were significantly
different from zero, the t-statistics were estimated based on the cross-sectional
variance of the predictive errors in the event period itself, x0
It is expected that the C P E ' s would be positive for upgrades and negative for
downgrades.
To provide evidence on the incremental information content of the bond
revisions, the following cross-section regressions 11 were estimated for the whole
sample as well as upgrades and downgrades separately:

A P E , = flo + i l l ( # G R A D E S ) + f12(AEPS) + fla(INV G R A D E )

APEk: the average prediction errors for company k for a window
of n weeks prior and n weeks after the announcement of
rating revisions;
#GRADES: the number o f grades changed - deducting the new ratings
from the old ratings;
AEPS: the unexpected percentage component of EPS for company
k estimated by a martingale model;

9 The zero-one model was chosen because it is difficult to know how, if at all, systematic risk of
equity changes with bond revisions. Furthermore, Brown and Warner (1980) provides some evidence
on the appropriateness of this methodology.
10Alternative methods of estimating the t-statistics under the conditions of event-induced variance is
discussed by Boehmer et al. (1991).
n Alternative experimental designs for cross-sectional model specification and the appropriateness of
the model proposed in Eq. (3) is discussed by Landsman and Magliolo (1988). Similar results are
obtained when the APE's are standardised to control for heteroscedasticity.
 Z.P. Matolcsy, T. Lianto /Journal of Banking & Finance 19 (1995) 891-902 897

INV GRADE: a dummy variable of '1' if the rating moves to an invest-

ment grade for an upgrade or to a non-investment grade for
a downgrade, otherwise '0'.
If rating revisions per se have incremental information content then the
expected sign of /31 is negative, since it's calculated as old ratings less new
ratings. 12 Hence for an upgrade (downgrade) #Grades is negative (positive)
whilst the predictive error is expected to be positive (negative).
Given the evidence of the information content of annual accounting income
numbers, the expected sign of/32 is positive, as an unexpected increase (decrease)
in EPS should result in a positive (negative) predictive error.
Finally, /33 is expected to be positive assuming that a movement into (out of)
investment grade had a favourable (unfavourable) effect on the predictive error.

4. The results

4.1. The joint information content of bond revisions and Accounting Annual
Income Numbers

The estimation of unexpected accounting income numbers indicated that 9 out

of 32 upgrades reported an unexpected negative EPS, whilst 7 companies out of 29
downgrades reported an unexpected increase in EPS. 13 Accordingly, the cumula-
tive predictive errors could be driven jointly by the information content of the
earnings announcement and the bond revision announcement. The cumulative
predictive errors for both the upgrades and downgrades summarised in Table 1 and
Fig. 1. As expected, bond upgrades have a positive trend in their CPE's, whilst
bond downgrades have a negative trend in their CPE's. In fact, a closer examina-
tion of Graph 1 indicates that much of the stock price revision takes place before
the announcement date of bond revisions. For upgrades the CPE has an aggregate
value of 7.88%, whilst the CPE has an aggregate value of - 9 . 4 2 % for down-
grades prior to the announcement date. Subsequent to the announcement date, the
CPE increases only by another 2.61% for upgrades and decreases by - 4 . 2 1 % for
downgrades as depicted on Fig. 1. However, the t-statistics indicate that all CPE's
are significant for the windows of - 17 to + 17, - 17 to 0, and from 0 to week 17
for both the upgrades and downgrades.
Accordingly, these results are consistent with the first hypothesis, that the joint

12 The highest grading had number 28 assigned to it, the lowest grading 1. The expected sign of fll
is based on the implied assumption that there is no conflict between the debt holders and the equity
holders.
13 There were a number of companies who had not, as yet, report their 1992 earnings figures leading
to a reduction in the number of observations in these estimates and in the regression runs in Section
4.2.
898 Z.P. Matolcsy, I". Lianto /Journal of Banking & Finance 19 (1995) 891-902

Table 1
Average and cumulative predictive errors for upgrades and downgrades

Week Upgrades Downgrades

Average Cumulative Average Cumulative

prediction prediction prediction prediction
error error error error

- 17 0.00000 0.00000
- 16 0.01024 0.01024 0.00458 0.00458
- 15 0.00578 0.01602 - 0.00803 - 0.00345
- 14 0.00437 0.02039 - 0.00285 - 0.00630
- 13 - 0.00501 0.01538 0.00605 - 0.00025
- 12 0.00638 0.02176 - 0.04088 - 0.04113
- 11 0.01248 0.03424 - 0.01455 - 0.05569
- 10 0.01177 0.04601 0.00036 - 0.05532
- 9 0.01176 0.05777 0.00183 - 0.05349
- 8 0.01043 0.06820 - 0.00375 - 0.05724
- 7 0.00145 0.06965 - 0.01221 - 0.06946
- 6 0.00020 0.06985 0.00087 - 0.06859
- 5 - 0.00281 0.06705 0.00311 -- 0 . 0 6 5 4 8
- 4 - 0.00630 0.06074 - 0.00143 -- 0 . 0 6 6 9 1
- 3 0.00606 0.06680 - 0.01270 -- 0 . 0 7 9 6 1
- 2 0.00641 0.07321 0.00432 - 0.07528
- 1 0.00339 0.07660 - 0.01425 - 0.08953
0 0.00227 0.07887 -- 0 . 0 0 4 7 0 - 0.09423
1 0.00442 0.08329 -- 0 . 0 0 7 0 0 - 0.10123
2 0.00813 0.09142 0.00927 - 0.09196
3 - 0.01010 0.08132 -- 0 . 0 0 1 7 2 -- 0 . 0 9 3 6 8
4 0.00240 0.08372 - 0.00378 -- 0 . 0 9 7 4 5
5 - 0.00073 0.07694 - 0.00733 -- 0 . 1 0 4 7 8
6 0.00223 0.07917 - 0.01095 - 0.11574
7 0.00768 0.08685 0.00592 - 0.10982
8 0.00061 0.08746 0.00520 - 0.10462
9 -- 0 . 0 0 1 4 2 0.08604 -- 0 . 0 0 6 1 3 -- 0 . 1 1 0 7 5
10 - 0.00323 0.08281 -- 0 . 0 0 9 4 9 -- 0 . 1 2 0 2 3
11 0.00794 0.09075 - 0.01294 - 0.13318
12 0.01211 0.10286 0.00085 -- 0 . 1 3 2 3 2
13 - 0.00003 0.10283 0.01604 -- 0 . 1 1 6 2 8
14 0.00314 0.10597 - 0.00464 - 0.12092
15 0.00148 0.10745 -- 0 . 0 0 2 0 3 - 0.12295
16 - 0.00535 0.10209 0.00441 - 0.11854
17 0.00293 0.10502 - 0.01781 - 0.13635
Week t-statistics t-statistics
-17+17 3.52 ° -3.34 *
- 1 7 to 0 3.03 * - 2.93 *
0to +17 2.54 * -3.17 *

* D e n o t e s s i g n i f i c a n c e at t h e 1 p e r c e n t l e v e l .
 Z.P. Matolcsy, T. Lianto /Journal of Banking & Finance 19 (1995) 891-902 899

0.2

0.15

0.1

0.05

--0,05

-0.1

-0.15

-0.2 I I | I I I i i

-20 -10 0 ~0 20

WEEK RELATIVE TO RATING ANNOUNCEMENT

O RATING DOWNGRADE + RATING UPGRADE

Fig. 1. Cumulative predictive error.

information content of unexpected accounting income numbers and bond revisions

is non-zero. The question still remains whether the post announcement CPE's are
driven by the marginal information content of bond revisions or just due to the
earnings drift effect. 14
The results in the next section provide some evidence on this issue.

4.2. The incremental information content of bond revisions

To test the incremental information content of bond revision announcements

multiple regression (3) has been estimated by using windows of - 5 to + 5 and
- 1 2 to + 12 of APEk's estimates. Table 2 depicts the key results of these
regression runs.
The results in Table 2 indicate that the coefficients of both the #GRADES and
AEPS are in the predicted direction and significant at the one percent level. The
sign of the coefficient of INV GRADE is unexpectedly negative, although it is
insignificant in both cases. The above evidence is consistent with the second
hypothesis that the incremental information content of bond revisions is non-zero.
To gain further insight into the incremental information content of bond

14 For a current debate on the earnings drift effect, see Ball and Kothari (1991).
900 Z.P. Matolcsy, T. Lianto / J o u r n a l of Banking & Finance 19 (1995) 891-902

Table 2
Cross-section regression test of the incremental information content of bond revisions for Windows of
- 5 to + 5 and - 1 2 to + 12 for all bond revisions
Independent variables
Intercept #GRADES AEPS INV GRADE Adj ~2
Predicted sign (- ) (+ ) (+)
Window - 5 + 5:
Est. coeff. 0.112 -0.097 0.049 -0.020 0.42
t-statistics -4.91 * 2.08 * -0.350
Window - 12 + 12:
ESt. coeff. 0.199 -0.158 0.150 -0.005 0.39
t-statistics -4.103 * 3.27 * -0.051
* Denotes signifance at the 1 percent level.

Table 3
Cross-sectional regression test of the incremental information content of bond upgrades/downgrades
for Windows of - 12 to + 12
Independent variables
Intercept #GRADES AEPS INV GRADE Adj "~2
Predicted sign (- ) (+ ) (+ )
Upgrades
Est. coeff. 0.19 - 0.089 0.054 0.016 0.09
t-statistics - 0.96 1.15 0.08
Downgrades
Est. coeff. 0.17 - 0.146 0.298 - 0.116 0.47
t-statistics -3.13 * 2.46 * -0.70
* Denotes signifance at the 1 percent level.

revisions, the s a m e m u l t i p l e regression has b e e n rerun o n the s u b s a m p l e s o f bond

u p g r a d e s / d o w n g r a d e s and the results are r e p o r t e d in T a b l e 3.
T h e results in T a b l e 3 indicate that for u p g r a d e s , the i n c r e m e n t a l i n f o r m a t i o n
c o n t e n t o f b o n d r e v i s i o n is not statistically significant, a l t h o u g h the sign o f
# G R A D E and A E P S are in the right direction. O n the other hand, for bond
d o w n g r a d e s , the c o e f f i c i e n t s o f these v a r i a b l e s are s i g n i f i c a n t w h i c h indicates that
the i n c r e m e n t a l i n f o r m a t i o n content o f b o n d d o w n g r a d e s n o n - z e r o . T h e tenor o f
these results are similar w h e n the w i n d o w for A P E k is c h a n g e d , although for s o m e
b r o a d e r w i n d o w s the c o e f f i c i e n t o f A E P S b e c o m e s statistically significant for both
the u p g r a d e s and the d o w n g r a d e s .

5. Conclusion
T h e results o f this study based on A u s t r a l i a n data are consistent w i t h the results
o f the studies by H o l t h a u s e n and L e f t w i c h (1986), H a n d et al. (1992), and by
 Z.P. Matolcsy, T. Lianto /Journal of Banking & Finance 19 (1995) 891-902 901

Comell et al. (1989) who, using different methodology, found that bond down-
grades have additional information content whilst bond upgrades do not. A c c o r d -
ingly, the main implication of this study is consistent with the view that rating
agencies only add value to the already existing information set on downgrades.
These findings could be consistent with the propositions that g o o d news travels
fast compared to bad news, or that equity holders are more concerned with a
downgrade than upgrades.
Future research could address these issues as well as a number of additional
issues such as; the relationship between the effect o f rating revision and the
revision of the systematic risk of underlying equities and the profitability of
trading rules based on bond revision announcements.

Acknowledgements

W e wish to thank G. Partington, I. Sharp, M. Stevenson, J. Winsen, the

members of the A M P Society, the participants of the w o r k s h o p at the University
of New South Wales and colleagues at the University o f Technology, Sydney for
their helpful comments. Special funding from the A c c u m u l a t e d Earnings of the
School of A c c o u n t i n g at the University of Technology, Sydney is gratefully
acknowledged. The vie~,s expressed in this paper reflect the views of the author
and not the official views o f A M P Society.

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