Senior and Subordinated Issues, Debt Ratings and Price Impact

Abstract

This paper investigates the question of whether bond ratings serve as a basis for market prices of bonds or whether investors use their own research and view the ratings only as rough guidelines. Unlike previous work, which focused on rating changes, this paper uses a new data base to consider bond ratings at issue. Agencies such as Moody's or S&P rate subordinated bonds by notching them down from senior bonds. We consider the pricing of both senior and subordinated issue. If notching policies were done properly, then we should find that all equally rated bonds should be priced equally (same yield). However, we find that the market systematically prices differently bonds of identical ratings but different seniority. Specifically, we find that yields of speculative senior bonds are higher than the yields of similarly rated subordinated bonds. The sign reverses in most cases for investment grade issues. We provide a possible explanation for the direction of the bias. We also control for issue and company characteristics.

Keywords: Debt ratings, senior and subordinated issues, notching, bond yields

JEL Classification: G32, G12