TAILIEUCHUNG - Informational efficiency of loans versus bonds: Evidence from secondary market prices

The credit quality of a bond depends on the issuer’s ability to pay interest on the bond and, ultimately, to repay the principal upon maturity. Independent bond-rating agencies evaluate the financial health of bond issuers and issue alphabetical credit-quality ratings. Usually a lower credit rating means that the issuer must pay higher interest to offset the higher risk that principal and interest won’t be repaid on time. Figure 2 on page 10 describes the ratings used by Moody’s Investors Service, Inc., and Standard & Poor’s weighted average rating of all the bonds in a fund is available from the mutual fund company | Informational efficiency of loans versus bonds Evidence from secondary market prices Edward Altman Amar Gande and Anthony Saunders First Draft November 2002 Current Draft October 2003 Preliminary Not for circulation Abstract This paper examines the informational efficiency of loans relative to bonds surrounding loan default dates and bond default dates. We examine this issue using a unique dataset of daily secondary market prices of loans over the 11 1999-06 2002 period. We find evidence consistent with a monitoring role of loans. First consistent with a view that the monitoring role of loans should be reflected in more precise expectations embedded in loan prices we find that the price reaction of loans is less adverse than that of bonds around loan and bond default dates. Second we find evidence that the difference in price reaction of loans versus bonds is amplified around loan default dates that are not preceded by a bond default date of the same company. Finally we find a higher recovery rate for loans as compared to bonds suggesting that the monitoring role of loans does not diminish significantly in the post default period. Our results are robust to controlling for security-specific characteristics such as seniority and collateral and for multiple measures of cumulative abnormal returns around default dates. Overall we find that the loan market is informationally more efficient than the bond market around default dates. JEL Classification Codes G21 G24 N22 Key Words loans bonds monitoring default event study Edward Altman is from the Stern School of Business New York University. Amar Gande is from the Owen Graduate School of Management Vanderbilt University. Anthony Saunders is from the Stern School of Business New York University. We thank Loan Pricing Corporation LPC Loan Syndications and Trading Association LSTA and Standard Poors S P for providing us data for this study. We thank Mark Flannery and Hans Stoll for helpful comments. We also thank Ashish .

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