Why do stock prices react to bond rating downgrades?

Prior research (e.g Holthausen and Leftwich, 1986) has found that firms’ stock prices react negatively to announcements of downgrades of their bond ratings. Our study examines whether stock prices react negatively to downgrades because the rating agency conveys adverse private information about the firm through the downgrade (the information provision hypothesis) and/or because the downgrade imposes significant costs on the firm (the cost imposition hypothesis). The results of a cross‐sectional model support both hypotheses. Specifically, we find that firms’ stock returns are positively related with their institutional stockholdings and negatively related with their debt‐to‐equity ratios. This suggests that the rating agency is an important information provider for firms with low institutional stockholdings, and that the downgrades significantly impact firms’ borrowing costs.