The Role of Default Risk in Determining the Market Reaction
to Debt Announcements
Sample and Methodology
To test default risk related implications of debt issuance, abnormal stock price reactions to new straight debt offers are examined. The initial sample was found by recording the debt filings reported in the “Recent Security Registrations” section of the Investment Dealer’s Digest (IDD) during the years 1984 to 1992. Any debt filings which represented convertible debt were excluded. In addition, any straight debt filings which coincided with filings for convertible debt, preferred stock, or common stock were deleted. The filing date, amount of the filing, and type of debt were recorded.
The Nexis on-line search system was used to check announcement dates. This service allows for searches of newspapers (including the Wall Street Journal and the
New York Times) and wire services (such as Reuters Financial Wire and PR Newswire). The announcement date is defined as the earliest date the debt offering is
mentioned in any of the searched sources. A two-day announcement period was considered.’ Observations were deleted if “other information” about a firm was reported
in these sources on the day prior to, the day after, or the day of the debt announcement.
Bond ratings assigned to each firm’s debt were chosen as the measure of default risk. The assertion employed by using bond ratings to proxy default risk is that default risk is lower for firms with “safer” debt ratings. Of course, bond ratings are an assessment of creditworthiness of an obligor with respect to a specific obligation. In general, this is not a significant problem since a large majority of firms exhibit identical ratings for all outstanding bonds. For firms with varying ratings, an overall bond rating was obtained by calculating a value-weighted average of the various ratings after converting ratings to numerical ran king^.^ Straight debt issues that preceded overall bond rating downgrades
were interpreted as indicating increased default risk, while those preceding overall rating upgrades were seen as signaling decreased default risk. Firms issuing new
debt but experiencing no overall bond rating change were interpreted as having insignificantly altered their default risk.