THE ROLE OF INFORMATION ASYMMETRY IN MARKET REACTIONS TO BOND RATING DOWNGRADES: EXPLORING THE IMPACT OF CORPORATE GOVERNANCE
This study examines the link between corporate governance and the information content of bond rating downgrades. A downgrade event contains more news and should generate more market reaction when the amount of financial information publicly available prior to the event is less. The more complete the information set before the event, the less the market response to the new information. Certain corporate governance mechanisms, especially those related to the boards of directors, are designed to defend shareholders from agency conflicts that give managers incentives to manage earnings and financial reporting. However, academic research has found mixed evidence as to the relation of corporate governance and transparent financial reporting. Perhaps in some cases, stronger corporate governance is necessary because the nature of the firm makes transparency in financial reporting too costly. My study attempts to provide evidence on the circumstances in which corporate governance is most valued by the market and suggests that the level of information asymmetry should be an important consideration in corporate governance research. The data analyzed in the study are taken from the Mergent Fixed Income Security Database [FISD] for bond rating downgrades. The time period spans both the implementation of Regulation FD and the Sarbanes-Oxley Act of 2002. I control for differences in regulatory regimes during the period. I find no consistent evidence that corporate governance structures weaken market reaction to bond ratings downgrades. However, I do show that the contrast of market reactions in the high and low governance conditions is most pronounced in conditions of high information asymmetry, and especially after the implementation of Regulation FD. My research contributes to the corporate governance literature by formally demonstrating that the level of a firm’s information asymmetry can be an important factor in determining the impact of corporate governance on the market reaction to an event. As an independent signal, bond rating downgrades provide a useful setting in which to examine this relationship.