S&P 500 Index revisions and credit spreads

• Author: Lindsay Baran,Ying Li,Xiaoling Pu,Zilong Liu,Chang Liu
• DOI: http://doi.org/10.1016/j.rfe.2017.12.001
• Published date: 01 October 2018
• Date: 01 October 2018

ORIGINAL ARTICLE

S&P 500 Index revisions and credit spreads

Lindsay Baran

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Ying Li

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Chang Liu

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Zilong Liu

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Xiaoling Pu

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Department of Finance, Kent State

University, Kent, Ohio

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School of Business, University of

Washington Bothell, Bothell, Washington

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Harmon College of Business and

Professional Studies, University of

Central Missouri, Warrensburg, Missouri

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Key Bank, Cleveland, Ohio

Correspondence

Lindsay Baran, Department of Finance,

College of Business Administration, Kent

State University, Kent, Ohio.

Email: lbaran@kent.edu

Abstract

We investigate the impact of S&P 500 Index revisions on credit spreads from

2001 to 2014. Additions have a significant negative impact on credit default swap

(CDS) spreads both during the financial crisis period and for speculative grade

firms, but deletions show no significant CDS spread changes. After excluding the

effect of market integration between the stock and CDS markets, we find that

S&P 500 Index inclusion conveys no unique information beyond that due to mar-

ket integration except during the financial crisis. Furthermore, CDS trading liquid-

ity does not improve after S&P 500 Index inclusion.

JEL CLASSIFICATION

G12, G14

KEYWORDS

credit default swap, credit spreads, S&P 500 Index revisions

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INTRODUCTION

Ever since the first documentation of price effects of Standard and Poor’s (S&P) Index revisions more than two decades

ago, researchers proposed multiple hypotheses to explain the stock price increases (decreases) associated with addition to

(deletion from) the S&P 500 Index.

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The stock price reaction to these announcements should either be information free,

resulting from downward-sloping demand curves for index stocks or price pressure from index fund rebal ancing, or it

should involve information relevant in pricing the newly added or removed stocks conveyed in S&P 500 Index revisions.

One strand of literature investigates information relevance in the credit market by studying the react ion in the credit market

to S&P 500 Index revision announcements and documents supporting evidence of the existence of information. For exam-

ple, Dhillon and Johnson (1991) find significant decreases in bond yield spreads after firms are added to the S&P 500

Index pointing to information in S&P 500 Index inclusion announcements.

In this paper, we examine the reaction in the credit default swap (CDS) market to S&P 500 Index revision an nounce-

ments and explore the underlying mechanisms of the effect. Compared with the bond market, the CDS market provides a

more liquid setting (Longstaff, Mithal, & Neis, 2005) for us to examine the reaction of credit spreads to equity index revi-

sions, especially over short-term windows. Not only does our study have a much larger sample size with more liquid credit

spreads data compared to that of Dhillon and Johnson (1991), but it employs the structural model of credit risk. Using the

structural model of risk, we can distinguish the market integration effect between equity and credit markets from the addi-

tional information in S&P 500 Index revisions that are uniquely identified in the CDS market.

We find that, over the period of 2001–2014, addition announcements have a negative and signifi cant impact on CDS

spreads. The CDS spread declines are significant over windows of up to 30 days post announcement date (AD), with an

increasing magnitude over time. The magnitude of negative abnormal CDS spread changes is larger during the financial cri-

sis period and for speculative grade firms for most windows that we examine. However, the differences between crisis and

non-crisis periods (or differences between investment grade and speculative firms) are not statistically significant. In con-

trast to index addition announcements, deletion announcements have a positive but statistically insignificant impact on CDS

Received: 17 April 2017

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Revised: 26 October 2017

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Accepted: 9 December 2017

DOI: 10.1016/j.rfe.2017.12.001

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©2018 The University of New Orleans wileyonlinelibrary.com/journal/rfe Rev Financ Econ. 2018;36:348–363.

spreads. The asymmetric reaction of CDS spreads to addition and deletion announcements is consistent with the findings in

Marsh and Wagner (2016), which shows that the price discovery in the CDS market is news-specific and only significant

following positive news. The stock market reaction to index inclusion is significant and positive for the full sample and

similarly larger magnitude of abnormal returns for speculative grade firms. However, the stock returns are positive but sta-

tistically insignificant for the crisis period. For the deletion sample, the stock cumulative abnormal returns (CARs) are sig-

nificantly negative for only a few windows.

The significant reactions to the addition announcements could be due to the CDS market participants uniquely identify-

ing new information from the S&P 500 Index revision announcement, or these reactions could simply stem from the price

integration between the CDS and equity markets (Fung, Sierra, Yau, & Zhang, 2008; Kapadia & Pu, 2012). To separate

these two effects, we employ the structural model to predict credit spreads and compute the abnormal changes in differ-

ences between the actual and predicted spreads for the event firms. We find that the significance of the abnormal differ-

ences disappears for the whole sample and low-rated firms and only appears in the crisis period. The results suggest that

S&P 500 Index revisions do not convey additional information to the CDS market that is unrecognized in the stock market

except during the financial crisis.

Furthermore, mirroring the existing S&P 500 Index revision literature, we test whether liquidity changes in the CDS

market lead to the abnormal CDS spread declines upon additions, as liquidity is also an important pricing factor for CDS

contracts (Bongaerts, De Jong, & Driessen, 2011; Loon & Zhong, 2014; Tang & Yan, 2014). We find that the CDS liquid-

ity does not significantly change in windows of up to 45 days after the inclusion announcements. In addition, the correla-

tions between CDS liquidity and abnormal spread changes are insignificant in all windows. Thus, liquidity improvements

do not drive our main results from the CDS market.

Exploring the determinants of both CDS and stock market reactions to index inclusion in a regression framework, we

find the stock CAR is an insignificant predictor of CDS spread changes in all but one event window. During the crisis per-

iod, we observe larger CDS spread declines. When we use the stock market reaction as the dependent variable, the CDS

CARs have no impact after controlling for other variables and the crisis dummy has no statistical significance. Based on

our full set of analyses, we find that index inclusion during the financial crisis was not information-free for CDS market

participants. However, our results from the CDS market do not show widespread support across all time periods and credit

ratings for any of the S&P 500 Index inclusion hypotheses.

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LITERATURE REVIEW AND MOTIVATION

Prior studies document a stock price reaction to inclusion in or removal from the S&P 500 Index. These studies find that

permanent stock price increases after S&P 500 Index inclusion and temporary stock price declines upon S&P 500 Index

removal. To explain the stock price reaction after S&P 500 Index revision announcements, researchers have proposed sev-

eral explanations which can be categorized into five competing hypotheses.

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The first hypothesis, downward-sloping demand curve hypothesis, argues that there is no information conveyed in S&P

500 Index revisions and the price effect arises because non-index stocks are imperfect substitutes for index stocks (Scholes,

1972). This hypothesis is supported by some previous work (Greenwood, 2005; Kaul, Mehrotra, & Morck, 2000; Lynch &

Mendenhall, 1997; Shleifer, 1986). A second explanation is that temporary price pressure from index fund rebalancing

drives these price changes, supported by Harris and Gurel (1986), Elliott and Warr (2003), Shankar and Miller (2006), and

Hrazdil (2009).

The remaining three hypotheses concur that index revisions are not information-free events, but each proposes a differ-

ent form of information transmission. The certification hypothesis deals with whether S&P 500 Index inclusion or remo val

conveys unknown information about future performance to explain the price response to announcements. Jain (1987) pro-

vides empirical evidence that S&P 500 Index addition conveys information to investors, which might change their percep-

tions of the stocks. Dhillon and Johnson (1991) investigate stock, bond, and option prices around the announcements of

inclusion in the S&P 500 Index and find bond and option prices to move with stock prices from 1978 to 1988, suggesting

that there is information involved in these announcements that impacts the equity, debt, and option markets. Denis et al.

(2003) and Platikanova (2008) also argue that addition to the S&P 500 Index is not information free by discovering earn-

ings improvement around the announcement date. In addition, Cai (2007) finds the positive addition information may

spread to the industry of the company.

On the other hand, Shleifer (1986) confirms the positive price effects after S&P 500 Index inclusion but argues that the

inclusion does not mean that the firm has improved quality because the abnormal returns are not related with the bond

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