“Surprise” in Distress Announcements: Evidence from Equity and Bond Markets∗

Some modified structural and reduced-form models of credit risk implicitly assume that the market has less information than managers who declare default on their outstanding debt. As a result the announcement of default or disclosure of information that indicates a firm is in distress comes as a “surprise” to the market. In this paper, we study the extent to which private information is revealed about a firm when it announces information indicating distress. The presence of this private information can be inferred from the extent to which investors can earn abnormal returns on bonds or equities issued by firms announcing distress or default. We analyze how much of the information revealed through the declaration of a credit event is publicly available before a specific announcement of credit difficulties. Using default probabilities supplied by Moody’s KMV (MKMV), known as the Expected Default Frequency—or the EDF—credit measure, we model market expectations regarding the firm’s likelihood of default. We then measure the impact of information revealed through an adverse credit event conditional on this expectation. We find that conditioning on EDF credit measures, only 11% of the distressed firms’ equities and 18% of the distressed bonds (belonging to 25% of the distressed firms) display a significantly negative “surprise” reaction in the sense that the price of these securities drops substantially following the announcement. The vast majority of prices for bonds and equities issued by these distressed firms reflect the firm’s credit deterioration well before announcement of default or distress. Most of these significant negative price reactions tend to occur when a firm declares bankruptcy. We also find that conditioning on lagged equity market returns, the extent of the “surprise” reflected in the corporate bond market shrinks, indicating that equity prices tend to be a leading indicator of a firm’s impending distress. This result, however, can also be due to differences in the samples of bonds and equities, or the lack of liquidity in the market for distressed corporate bonds. Our findings are robust to the choice of time horizon of analysis, and to the choice of publicly available information other than EDF credit measures. Our results have implications for determining the appropriate framework for modeling credit risk. ∗Address correspondence to Dr. Jeffrey R. Bohn, Managing Director, Research Group, Moody’s KMV, 1620 Montgomery Street, San Francisco, CA 94111. E-mail: [email protected]