Bond

J. Finan.
Intermediation xxx (2014) xxx–xxx
Contents lists available at ScienceDirect
J. Finan. Intermediation
j o u r n a l h o m e p a g e : w w w . e l s e v i e r . c o m / l o c a t e / j fi
Equity short selling and bond rating downgrades

Tyler R. Henry a,⇑, Darren J. Kisgen b, Juan (Julie) Wu c
a
Farmer School of Business, Miami University, Oxford, OH 45056, USA
b
Carroll School of Management, Boston College, Chestnut Hill, MA 02467, USA
c
Terry College of Business, University of Georgia, Athens, GA 30602, USA
a r t i c l e i n f o a b s t r a c t
Article history: We examine whether short sellers identify firms that have signifi-
Received 7 July 2012 cant changes in default likelihoods and credit rating downgrades.
Available online xxxx In the month before a rating downgrade, equity short interest is
40% higher than one year prior. Short sellers predict changes in
Keywords:
default probabilities that lead to downgrades by focusing on firms
Credit ratings
with inaccurate or biased ratings. This strategy is profitable for
Default risk
Short selling
short sellers primarily since downgrades are associated with sig-
nificantly negative equity returns. Short sellers also facilitate price
discovery by reducing abnormal stock returns following down-
grades and by leading bond yield spreads.
Ó 2014 Elsevier Inc. All rights reserved.
1. Introduction
The role of short sellers in financial markets is controversial. Short sellers could be a negative force
for markets if they increase market volatility and instability, or short sellers could be a positive force if
they increase market efficiency and price discovery. A necessary condition for short sellers to provide a
market efficiency role is that they are informed traders. We examine this hypothesis in a novel setting,
around bond rating downgrades, a setting in which short sellers are arguably at an informational
disadvantage relative to bond investors. Previous research has shown that rating downgrades affect
equity returns on average negatively.1 We test whether short sellers can anticipate these downgrades
by understanding or anticipating changes in default probability, and whether they use other
⇑ Corresponding author. Fax: +1 513 529 6992.

E-mail addresses: henrytr3@miamioh.edu (T.R. Henry), darren.kisgen.1@bc.edu (D.J. Kisgen), juliewu@uga.edu (J. Wu).
1
See Griffin and Sanvicente (1982), Holthausen and Leftwich (1986) and Goh and Ederington (1993) for evidence of negative
equity returns following credit rating downgrades.
http://dx.doi.org/10.1016/j.jfi.2014.02.005
1042-9573/Ó 2014 Elsevier Inc. All rights reserved.
Please cite this article in press as: Henry, T.R., et al. J. Finan. Intermediation (2014), http://dx.doi.org/10.1016/
j.jfi.2014.02.005
2 T.R. Henry et al. / J. Finan. Intermediation xxx (2014) xxx–xxx
ratings-specific information to identify these downgrades. A second avenue for evaluating the role of
short sellers is to see if their activity aids directly in price discovery. Since equity returns following bond
downgrades have been shown to exhibit post-announcement drift (Dichev and Piotroski, 2001), down-
grade events provide a useful laboratory to examine this question directly. In particular, we investigate
whether short sellers provide an efficiency role in identifying firms likely to be downgraded, in advance
of potentially slower action by rating agencies or bond investors.
We first test the hypothesis that short sellers are sophisticated investors who can accurately pre-
dict rating downgrades. Consistent with this hypothesis, we find that short interest increases signifi-
cantly prior to downgrades. For example, in the month before a rating downgrade, short interest is 40%
higher than 12 months prior. We undertake several additional approaches to confirm that these re-
sults are due to ratings specifically. We begin by matching downgraded firms to a benchmark portfolio
of non-downgraded firms with similar fundamentals (including previous returns), we eliminate obser-
vations with ‘‘contaminating’’ events such as earnings announcements or mergers, and we examine
abnormal short interest levels, such that each firm’s short interest is differenced relative to its previ-
ous short interest. We also examine several interactions to identify downgrade specific activity. We
find that short interest is higher for those downgrades that incur more negative equity announcement
returns. We find that short interest increases more when the firm is rated BBB prior to the down-
grade, the lowest investment grade rating. If the increased short selling prior to a downgrade were
due to deteriorating fundamentals of the firm, the distinction between BBB and BB+ should be irrel-
evant. But a downgrade from investment grade to speculative grade is likely to have a significant im-
pact on bond prices, both for regulatory as well as fundamental reasons (Kisgen and Strahan, 2010).
We find that abnormal short selling is higher prior to downgrades that span several ratings categories
and for downgrades across a rating category (e.g., AA to A+) compared to within a rating category
(e.g., AA to AA). Lastly, we examine whether short sellers time rating downgrades more effectively
following the passage of Regulation FD. Jorion et al. (2005) find that announcement effects of rating
changes are larger after RegFD, reflecting the relative informational advantage ratings agencies enjoy
in a post RegFD world. Consistent with short sellers trading on ratings events specifically, we find that
short selling prior to downgrades is larger after RegFD. This collective evidence supports the conclu-
sion that increased short selling before downgrades is directly credit rating related and not simply due
to deteriorating equity fundamentals.2
Our next set of tests examines how short sellers identify firms likely to be downgraded. One poten-
tial avenue is that short sellers understand changing default probabilities, either by recognizing
changes in default probabilities before they are incorporated into ratings, or by predicting future
changes in default risk. We provide evidence consistent with both of these avenues. Short selling is
particularly high before a downgrade when the firm experiences significant increases in default prob-
abilities, and short sellers in general predict large subsequent changes in default probabilities. We also
explore whether short sellers make use of bond rating specific information to anticipate downgrades.
Credit rating downgrades have been shown to experience momentum (Altman and Kao, 1992; Lando
and Skodeberg, 2002). Short sellers might therefore use a previous downgrade as an indication of a
likely subsequent downgrade. Consistent with this, we find that abnormal short selling is higher for
downgraded firms in cases in which the firm was previously downgraded in the last 12 months. We
also consider whether short sellers identify firms with inaccurate ratings, either due to slow reactions
to changes in default probabilities, or due to upwardly biased ratings (as in Kraft, 2011). In both cases,
we identify higher short selling before downgrades using this information. Lastly, we consider
whether short sellers might use the changes in measures of adverse selection that have been shown
to also predict rating downgrades as in Odders-White and Ready (2006). We find evidence that short
selling is higher before a downgrade when the probability of informed trading increases and when the
2
One other explanation for our results is that rating agencies use the level of short interest to determine whether they should
downgrade a firm, or perhaps short sellers try to manipulate rating agencies into downgrading a firm. To test this conjecture, we
instrument the level of short selling using both options trading as well as the passage of a regulation altering restrictions on short
selling for a subset of firms (‘‘RegSHO’’), but we do not identify a significant causal link from short interest to a downgrade.
Although we cannot completely rule out a manipulation story, we conclude that other interpretations are more plausible given the
weight of the evidence.
j.jfi.2014.02.005
T.R. Henry et al. / J. Finan. Intermediation xxx (2014) xxx–xxx 3
probability of an information event increases. These results support the hypothesis that short sellers
are informed traders who anticipate rating downgrades by using rating-specific information.
Implicitly, we argue that short sellers anticipate downgrades so they can capture the negative equi-
ty returns associated with a downgrade. We conduct several tests to verify this by examining the prof-
itability of short selling before a downgrade. Short selling before a downgrade can begin as much as
12 months before the downgrade, and we find that over that time period, excess short selling achieves
a 7% market-adjusted positive return. On a shorter-term basis, high short selling the month before a
downgrade leads to a risk adjusted return (four-factor alpha) of 2.35% in the month of a downgrade.
The return is higher when the short selling also corresponds to large changes in default probabilities
prior to the downgrade. Results from a probit model also show that short interest levels predict rating
downgrades.
Our last set of tests examines whether increases in short selling before a downgrade aids in price
discovery and whether short sellers anticipate rating downgrades before the bond market. We find
that increased equity short selling precedes changes in bond spreads prior to a downgrade. Although
both bond and equity markets substantially anticipate rating downgrades before they occur, for the
average downgraded firm abnormal short selling begins 12 months prior to the downgrade, whereas
bond spreads do not materially change until three months prior. We also find that pre-downgrade
short selling is related to post-downgrade equity return drift. Dichev and Piotroski (2001) document
persistent negative abnormal equity returns in the year following a downgrade, which they interpret
as underreaction to the downgrade announcement. We find that abnormal returns following a down-
grade dissipate faster for firms with higher levels of abnormal short interest. We also find that the
underreaction to a downgrade is larger when short selling is more constrained (proxied by a firm hav-
ing low levels of institutional ownership or subject to the uptick rule). We conclude that short selling
aids in price discovery for negative bond events, and short sellers provide an efficiency role that pre-
cedes the bond market’s reaction.
To the best of our knowledge, our paper is the first to show that short sellers predict changes in
default probabilities and rating downgrades. Our paper is also the first to show that short sellers facil-
itate price discovery around credit events. Other papers have shown that short sellers predict changes
to firm fundamentals, but none of these focus on changes in default likelihood.3 Bond-related events
represent a setting in which equity short sellers may be at a disadvantage, yet we show that despite this
disadvantage, short sellers predict these events. We also identify several strategies that short sellers
implement unique to a bond rating downgrade, and we confirm that the short selling strategies are prof-
itable. Other papers also examine how short sellers facilitate price discovery (Bris et al., 2007; Chang
et al., 2007; Boehmer and Wu, 2013), but none focus on credit events such as default and rating
downgrades.
Rating downgrades provide a useful laboratory for testing price discovery given slow price reac-
tions to bond rating downgrades (Dichev and Piotroski, 2001). This setting also provides evidence
on information transmission between bond and equity investors. Hotchkiss and Ronen (2002) find
that stocks do not lead bonds in reflecting firm-specific information, whereas Kwan (1996) finds that
stocks do lead bonds in firm-specific information. Our results provide an important example consis-
tent with the Kwan (1996) results. Finally, our paper complements a contemporaneous paper by
Kecskés et al. (2013) who examine whether short selling provides information to creditors in the bond
market. Their paper primarily focuses on the relationship between short selling and bond yields with
some attention to ratings, whereas we focus entirely on the relationship between short selling and
credit ratings. Our evidence also indicates that short sellers anticipate downgrades, and we explicitly
link short sellers’ profits to their ability to process default information. Thus, we focus on a different
flow of information, from changes in default risk to increased short selling in anticipation of a rating
downgrade.
3
For example, Christophe et al. (2004) find that short selling is significantly linked to post earnings announcement stock returns,
Christophe et al. (2010) find that short selling increases prior to equity analyst downgrades, and Karpoff and Lou (2010) find that
increased short selling precedes SEC enforcement action on financial statement misrepresentation. Short sellers also appear to use
fundamental analysis to predict abnormally negative equity returns generally (Dechow et al., 2001; Desai et al., 2002; Cao et al.,
2007).
j.jfi.2014.02.005
2. Hypotheses
Credit rating changes impact equity returns (Griffin and Sanvicente, 1982; Holthausen and
Leftwich, 1986; Goh and Ederington, 1993). In particular, credit rating downgrades by Moody’s or
S&P correspond to decreases in stock prices, but upgrades have little impact on share prices. These
studies indicate that the negative stock returns following downgrades are robust to the exclusion of
observations with contaminating events, such as earnings announcements or mergers. Short sellers
may therefore reasonably attempt to anticipate potential bond downgrades.
The model of Diamond and Verrecchia (1987) describes short sellers as informed traders who profit
from their negative private signals. We design several hypotheses to test whether short sellers are in-
formed with regard to credit rating downgrades, to test for the source of their private signals, and to
test whether their trading strategies are profitable. Our first hypothesis examines whether short sell-
ers are able to identify and trade in advance of future credit rating changes.
H1. Short sellers are informed investors that can anticipate credit rating changes, and begin to trade
months in advance of the downgrade event.
Previous empirical literature indicates that short sellers make informed trades, such that firms with
higher short selling have lower subsequent abnormal returns.4 Short sellers have also been shown to
anticipate other announcements that affect equity prices, such as earnings announcements (Christophe
et al., 2004), announcements of SEC sanctions related to financial misrepresentation (Karpoff and Lou,
2010), and earnings restatement announcements (Desai et al., 2006; Efendi and Swanson, 2009). H1 also
implies that increases in short selling prior to a downgrade should be reflected through ratings-specific
channels. To provide additional evidence in support of H1, we examine interactions between pre-down-
grade short selling and variables that are specific to the credit rating information environment, such as
the implementation of Regulation FD, changes in adverse selection around downgrades, and downgrades
surrounding the investment grade threshold.
Our next hypothesis investigates the source of short sellers’ private signals, and whether it is driven
by changes in default probabilities.
H2. Short sellers’ ability to anticipate downgrades is related to their ability to predict or understand
changes in default probabilities.
The probability of default is the single most important factor for a bond credit rating (Standard and
Poor’s, 2011). Changes in default probability occur continuously, but bond rating changes are discrete
and often infrequent events. Thus, a bond rating change may lag a large change in default risk, and
markets may not fully incorporate this information until the time of the downgrade. Identifying or
predicting large increases in default risk in advance of rating agency action therefore may generate
sensible short selling trading strategies.
If trading by short sellers is informationally motivated, their trades should be profitable. Our third
hypothesis addresses this point.
H3. Short sellers generate abnormal returns from their downgrade-related trading strategies.
We investigate several strategies short sellers might implement to exploit rating downgrades. H3
implies that short sellers use their information about changes in default risk and future downgrade
activity to form potentially profitable trading strategies. We test for profitability of the strategies using
several techniques.
Short selling could make prices more efficient by incorporating news into prices more quickly (Diamond
and Verrecchia, 1987). Thus, we explore the role of downgrade-related short selling for price discovery.
4
See Asquith and Meulbroek (1996), Desai et al. (2002), and Asquith et al. (2005) for results using monthly short interest. See
Boehmer et al. (2008), and Diether et al. (2009) for results using daily shorting volume.
j.jfi.2014.02.005
H4. Short selling around bond downgrades contributes to price discovery.
Previous literature indicates that stock prices underperform for 12 months following a bond rating
downgrade (Dichev and Piotroski, 2001), suggesting that equity markets underreact to the downgrade.
To the extent short selling increases in anticipation of a downgrade, short selling might move prices
more quickly to their appropriate level. If short selling provides a price discovery role, post-downgrade
return drift will be reduced for firms with higher short interest before the downgrade. We also test the
price discovery hypothesis by examining firms that are costly to short sell compared to those that are
not. If short selling aids in price discovery, we expect that post-downgrade drift will be reduced for
firms where short selling is least costly, and will persist for firms where short selling is expensive.
And finally, we examine the timing of short selling relative to changes in bond spreads. For short sell-
ing to be most impactful, short selling levels should increase prior to changes in bond spreads, which
would indicate that short sellers anticipate downgrades prior to the bond market. Short sellers how-
ever could be at an informational disadvantage relative to bond investors, since a rating downgrade is
a bond event.
3. Data
We obtain monthly short interest data from Compustat (after 2003) and from the market centers
(e.g., NYSE, Amex, and Nasdaq) prior to 2003.5 A firm’s short interest is a snapshot of the total number of
outstanding short positions each month, so it is stock, rather than flow, data. Our sample is from April
1995 to December 2007.6 We scale each firm’s monthly short interest by its total shares outstanding.
Since short interest is persistent, we subtract from a stock’s monthly short interest its moving average
over the past three months to represent the shock to a firm’s short interest.7 This adjustment also cor-
rects for time invariant omitted variables that might lead to higher short interest and higher probabilities
of downgrades generally. A large increase suggests abnormally high short interest relative to its own re-
cent shorting activity.
After these adjustments, we match each downgraded firm to a benchmark portfolio of rated but
non-downgraded firms, using two different methods. First, we match a downgraded firm to a bench-
mark portfolio based on size, book-to-market and momentum (prior literature shows that short inter-
est is related to these firm characteristics (Duarte et al., 2006). Specifically, we construct 27 (3 3 3)
portfolios at the beginning of each month by independently sorting stocks on market capitalization,
book-to-market, and momentum, all measured at the end of the prior month (excluding event firms
when forming benchmark portfolios). Momentum is defined as a stock’s cumulative returns over the
past 12 months. We use other criteria for matching in robustness tests. The second method is to use
propensity score matching to identify the benchmark portfolio.8 The matching begins with a Probit
regression of a downgraded dummy variable on market capitalization, book-to-market, momentum,
4-digit SIC code, and credit rating level, all of which are lagged by one month. We then use the propensity
scores from this Probit estimation and match each downgraded firm to the ten nearest neighbor non-
downgraded firms (with replacement). This procedure ensures that a downgraded firm is paired with
ten non-downgraded firms with statistically the same probability of a downgrade based on market cap-
italization, book-to-market, momentum, industry, and credit rating. For both matching procedures,
5
We focus on monthly short interest because downgrades differ from other corporate events such as earnings announcements,
in that the date of the event is unknown to a short seller (unless they receive inside information about the date). In unreported
tests, we use daily short selling data to test the hypothesis that short sellers have insider information regarding the timing of rating
downgrades. We do not find evidence that short sellers trade based on advance knowledge of the exact downgrade date.
6
During our sample period, the exchanges collect short interest data on the fifteenth day of the month (if it is a trading date),
which represent the short positions that had settled by this date. Since trades settle t + 3 after June 1995, these short positions are
those that were outstanding on the trade date 3 days prior. We account for this timing when matching short interest observations
to credit rating changes.
7
We also use moving averages over 6 or 12 months and the results are not sensitive to the choice on the length of moving
windows.
8
For a detailed description of the benefits of propensity score matching in corporate finance applications, see Drucker and Puri
(2005), Li and Prabhala (2005), and Hellmann et al. (2008).
j.jfi.2014.02.005
abnormal short interest (ABSI) of an event firm is the difference between the above short interest mea-
sure and that of its benchmark portfolio.
Data on credit rating changes are obtained from the Mergent Fixed Investment Securities Databases
(FISD). We use similar procedures as Jorion et al. (2005) to construct our sample, which includes all
U.S. domestic corporate bonds, excluding convertible or exchangeable bonds, Yankee bonds, and
bonds issued through private placement. Ratings include those from all three major credit rating agen-
cies (S&P, Moody’s and Fitch) from April 1995 to December 2007. We treat each bond rating change
from one credit rating agency as one event. In cases of multiple rating changes on the same day,
we retain the largest magnitude rating change.9 These events are more likely to generate the strongest
market reactions. In cases where rating changes are made consecutively by the credit rating agencies on
separate days within the same month, we retain the one with the earliest date, due to the monthly fre-
quency of short interest data. When matching monthly short interest observations to credit rating
changes, we account for the timing issues related to short interest data collection by the exchanges.
For example, when a credit rating announcement in a given month occurs after the short interest collec-
tion date, we match the following month’s short interest to this event.
Since our objective is to identify whether short sellers anticipate credit rating changes and not
other corporate events, we ‘‘decontaminate’’ the credit rating announcement by eliminating any
observation with a concurrent non-rating related material announcement. We first exclude rating
changes that are coded in the FISD data as being due to ‘‘mergers and acquisitions’’ or ‘‘market condi-
tions’’. We then exclude rating changes that occur within the same week of a firm’s quarterly earnings
announcement. Excluding these observations helps isolate the information content of the rating
change specifically. We also cull news announcements around the time of the rating change and re-
move observations which have concurrent events. We also require at least six monthly observations
both before and after each rating change event to examine how short interest varies around rating
changes, and we exclude firms with a share price less than $5 in the month prior to the rating
changes.10 Our final sample consists of 1463 downgrades.
Corporate bond yield data come from the trades reporting and compliance engine (TRACE) data-
base, which is disseminated by the Financial Industry Regulatory Authority (FINRA). The TRACE data
are available beginning in July 2002 (see Edwards et al. (2007) for further details). We perform several
filters on the TRACE data before calculating our bond yield measures. We include only regular trades
with non-special conditions, we correct misreported trades as identified by TRACE, and we eliminate
cancelled trades and duplicate inter-dealer trades. Finally, to exclude potential data entry errors, we
eliminate ‘‘reversal’’ trades using the price filter of Bessembinder et al. (2006). After these data-cleans-
ing filters, we calculate the equal-weighted average daily bond yield for the bonds in the sample. We
then match the TRACE data to the FISD credit ratings data to construct rating and maturity-based bond
benchmarks. To create the benchmarks, we follow the procedure of Covitz and Harrison (2003) and
form 56 daily yield indices according to rating and maturity. There are seven ratings categories:
AAA, AA, A, BBB, BB, B, and CCC or less.11 The eight maturity categories are determined by whether
the bond’s maturity is closest to 1, 2, 3, 5, 7, 10, 15, or 20 years. We average the daily yields of each index
over the month, giving us a monthly benchmark yield for each index.
Once we have constructed the bond yield benchmarks, we calculate a monthly yield spread for the
bonds in our downgrade sample by matching each bond to one of the 56 indices. The yield spread is
the difference between the average monthly yield of the downgraded firm and the monthly yield of
the matched benchmark index, based on the bond’s rating and maturity in the month prior to the
downgrade. Finally, we calculate the change in yield spread for our downgraded firms in the months
leading up to the credit rating change. The primary interest here is whether the change in yield
spreads is related to abnormal short selling activity. Any relation between the two may provide evi-
dence of price discovery across markets.
9
This could occur when a single bond issue from an issuer receives a rating change from multiple rating agencies, or when
several bond issues from the same issuer receive rating changes of different magnitudes from the same rating agency.
10
D’Avolio (2002) documents that many stocks with a price below $5 are nearly impossible to short.
11
We form a composite rating by using the average rating of all three rating agencies, where available. The composite rating is
rounded down to the lower rating category when in between categories. We compute the composite rating at each point in time.
j.jfi.2014.02.005
Fig. 1. Distribution of abnormal returns around credit rating downgrades. Abnormal return is calculated as raw returns minus
value-weighted market returns.
Fig. 1 shows the distribution of abnormal announcement returns (measured as raw returns minus
CRSP-value-weighted market returns) for credit rating downgrades in our sample. While
announcement returns are negative on average for credit rating downgrades (the average 3-day
CAR is 1.12% in our sample), the distribution includes a significant number of positive or near zero
announcements. In some non-negative cases, the downgrade could have been anticipated due to a
deterioration of other firm fundamentals. In other non-negative cases, a downgrade could be good
for shareholders, if the downgrade occurs due to an increase in firm value volatility or if increases
in leverage are perceived to be value enhancing. For example, Maxwell and Stephens (2003) find that
bonds are twice as likely to be downgraded rather than upgraded after the announcement of share
repurchase programs, which are generally followed by positive abnormal stock returns. Our study
therefore differs from many other studies of short selling around corporate events (e.g., in their study
of short selling around SEC enforcement actions, Karpoff and Lou (2010) note that 98.5% of firms with
SEC enforcement actions have negative abnormal announcement returns). This distinction aids in our
identification of the causal relationship of interest. We conduct falsification tests using firms that are
downgraded but that did not have negative announcement returns for the downgrade. Informed short
sellers trading for profit should increase their short selling in the instances where the downgrade leads
to negative returns.
4. Results
Our results highlight four main points which parallel our four hypotheses. We show that short sell-
ers anticipate rating downgrades, that this anticipation is related to changes in default probabilities,
that downgrade related short selling is profitable, and finally that short sellers enhance price discovery
around downgrades.
4.1. Short selling and anticipation of downgrades
We provide two sets of results on the relationship between short selling and future downgrades
specified in H1. The first set of results uses the sample of downgraded firms; the second set of results
uses the sample of all rated firms.
4.1.1. Abnormal short selling prior to downgrades

We first examine how abnormal short interest varies around rating changes for the whole sample
of downgraded firms. Table 1 shows abnormal short interest from 18 months prior to 12 months after
a rating downgrade. Column 1 reports the abnormal short interest relative to a benchmark portfolio
matched on size, book-to-market, and momentum. The benchmark portfolio used in column 2 (3)
additionally matches on Earnings/Price (Cash Flow/Price). We match using these additional character-
istics because Dechow et al. (2001) and others document that short selling is related to these firm
j.jfi.2014.02.005
Table 1
Abnormal short interest around credit rating downgrades.
Relative month (1) (2) (3)

Match on size, B/M, Mom Additional match on E/P Additional match on CF/P
ABSI (%) t-Stat ABSI (%) t-Stat ABSI (%) t-Stat
18 0.01 (0.29) 0.01 (0.39) 0.00 (0.11)
17 0.04 (1.25) 0.04 (1.24) 0.04 (1.25)
16 0.04 (1.29) 0.04 (1.26) 0.03 (0.80)
15 0.02 (0.67) 0.01 (0.33) 0.01 (0.34)
14 0.00 (0.14) 0.01 (0.24) 0.00 (0.14)
13 0.04 (1.34) 0.03 (1.19) 0.01 (0.27)
12 0.08 (2.58) 0.08 (2.69) 0.05 (1.61)
11 0.08 (2.25) 0.07 (2.07) 0.06 (1.44)
10 0.09 (2.53) 0.08 (2.13) 0.07 (1.64)
9 0.08 (2.28) 0.05 (1.56) 0.06 (1.70)
8 0.10 (2.90) 0.09 (2.66) 0.10 (2.66)
7 0.11 (2.81) 0.10 (2.54) 0.12 (2.74)
6 0.16 (4.12) 0.15 (3.87) 0.15 (3.57)
5 0.18 (4.55) 0.16 (4.05) 0.20 (4.60)
4 0.19 (4.98) 0.18 (4.76) 0.20 (4.82)
3 0.21 (5.07) 0.19 (4.86) 0.19 (4.63)
2 0.24 (5.94) 0.22 (5.54) 0.21 (4.86)
1 0.24 (5.42) 0.21 (4.85) 0.21 (4.50)
0 0.21 (4.36) 0.19 (4.05) 0.22 (4.02)
1 0.19 (3.97) 0.18 (3.88) 0.20 (3.70)
2 0.11 (2.53) 0.09 (2.12) 0.10 (2.07)
3 0.03 (0.69) 0.02 (0.49) 0.06 (1.12)
4 0.05 (1.08) 0.04 (0.88) 0.05 (1.03)
5 0.02 (0.36) 0.01 (0.31) 0.01 (0.29)
6 0.06 (1.33) 0.05 (1.23) 0.07 (1.51)
7 0.01 (0.31) 0.02 (0.41) 0.01 (0.29)
8 0.03 (0.62) 0.03 (0.52) 0.02 (0.31)
9 0.00 (0.08) 0.01 (0.23) 0.01 (0.19)
10 0.07 (1.67) 0.07 (1.68) 0.06 (1.36)
11 0.04 (0.91) 0.04 (1.01) 0.02 (0.35)
12 0.02 (0.42) 0.02 (0.52) 0.02 (0.42)
This table reports average abnormal short interest (ABSI) around credit rating downgrades. Short interest is calculated as total
short interest divided by shares outstanding. In column 1, ABSI is the event stock’s relative short interest in excess of the mean
relative short interest of a portfolio benchmarked on size, book-to-market, and momentum, where relative short interest refers
to a stock’s monthly short interest minus its moving average over the past 3 months. Column 2 (3) additionally matches on
earnings/price (cash flow/price). The sample consists of 1463 credit rating downgrades of U.S. domestic non-convertible cor-
porate bonds from April 1995 to December 2007.
characteristics and consequently to subsequent returns. The sample for all tests is also decontami-
nated, such that firms with significant coinciding events within 3 days of the event are removed.
Table 1 and Fig. 2 show that short interest is abnormally high beginning 12 months prior to the
downgrade, peaking one month before the downgrade. These results indicate that short sellers are
able to anticipate rating downgrades. Since our benchmarking procedure matches to firms with sim-
ilar fundamentals, the increased short interest is unrelated to trading based on other fundamental
strategies identified in previous studies.12 The average raw short interest in the month prior to the
downgrade is 4.35%, which is approximately 40% higher than the average raw short interest 12 months
prior to the downgrade (3.12%).
Now that we have documented a relationship between short selling and subsequent credit rating
downgrades, we next examine several rating specific factors to isolate whether the activity is rating
12
As illustrated in Fig. 2, the results are very similar whether we use portfolio matching or propensity score matching in our
measure of ABSI. For brevity, and to be consistent with the existing literature, we only show results from the portfolio matching
benchmark for the remainder of the paper.
j.jfi.2014.02.005
Fig. 2. Abnormal short interest around downgrades. This figure shows the level of abnormal short interest under two separate
matching procedures. In the first procedure (portfolio match), abnormal short interest is the event stock’s relative short interest
in excess of the mean relative short interest of a portfolio benchmarked on size, book-to-market, and momentum. In the second
procedure (propensity score match), abnormal short interest is the event stock’s relative short interest in excess of the mean
relative short interest of the 10 firms with the nearest propensity score to the event firm. Propensity scores are calculated with a
logit regression using size, book-to-market, momentum, industry, and credit rating as explanatory variables. Relative short
interest refers to a stock’s monthly short interest minus its moving average over the past 3 months.
specific. Despite having decontaminated the sample and matched observations based on fundamen-
tals, one might still be concerned that the relationship is not specific to the ratings changes
themselves. Using the sample of downgraded firms, we examine in a multivariate setting which
downgraded firms are more likely to have greater short interest preceding the downgrade, using
the following regressions:
X
K
ABSIt1 ¼ a þ bðCRFactort Þ þ kk X k;t2 þ e ð1Þ
k¼1
ABSI is abnormal short interest measured at one month prior to downgrade. CRFactor in Eq. (1) is a spe-
cific credit rating factor that we propose should be associated with higher levels of abnormal short
interest prior to a downgrade if the short selling is specifically due to ratings. X includes K control vari-
ables from previous literature that predict levels of abnormal short selling. We begin by examining
whether short interest is higher when downgrades are more severe, including downgrades from
investment grade to speculative grade, downgrades across several ratings categories, and downgrades
‘‘across class’’ (for example, from AA to A+ as opposed to AA to AA). If short sellers are informed
with respect to rating downgrades, they should be targeting these severe downgrades that have more
negative announcement returns. If short sellers are merely trading on fundamentals however, we
should not expect to see significant differences in short selling for these ratings specific distinctions.
We also create an indicator variable to signify downgrades that are a ‘‘surprise’’. To isolate downgrade
specific activity, the surprise indicator variable is defined as downgraded firms whose 12-month
cumulative abnormal stock returns prior to the downgrade are non-negative, but whose announce-
ment returns are negative. The full sample results for all downgrades include firms with significant
negative stock returns preceding the downgrade. To the extent that short sellers make use of return
momentum or other fundamental strategies separate from rating downgrade specific strategies, we
would expect increased short selling in these firms regardless of whether the firm was ultimately
downgraded.13 This test offers another potential verification that the short selling we have identified
is ratings specific, since these types of firms are excluded from the interaction term. Downgrades for
13
Diether et al. (2009), however, identify an opposite strategy when focusing on short-term strategies, where short sellers seem
to exploit mean reversion in equity prices with respect to past few days returns.
j.jfi.2014.02.005
Table 2
Multivariate analysis of abnormal short interest prior to downgrades.
Variable (1) (2) (3) (4) (5)

Coef. t-Stat Coef. t-Stat Coef. t-Stat Coef. t-Stat Coef. t-Stat
Panel A: Measures of downgrade severity
BBB 0.0045 (2.67) 0.0039 (2.27)
Multinotch 0.0032 (2.75) 0.0027 (2.34)
Surprise 0.0028 (2.35) 0.0025 (2.11)
AcrossClass 0.0017 (1.98) 0.0000 (0.01)
LnME 0.0004 (1.15) 0.0004 (1.25) 0.0003 (1.04) 0.0004 (1.26) 0.0003 (1.14)
B/M 0.0006 (0.87) 0.0007 (0.97) 0.0007 (0.97) 0.0007 (0.95) 0.0006 (0.82)
12 mo. prior return 0.0038 (2.89) 0.0038 (2.90) 0.0052 (3.35) 0.0038 (2.90) 0.0050 (3.30)
Inst. Own. 0.0012 (0.25) 0.0015 (0.32) 0.0015 (0.32) 0.0014 (0.29) 0.0013 (0.28)
Volatility 0.0767 (1.36) 0.0875 (1.53) 0.0726 (1.26) 0.0762 (1.34) 0.0910 (1.60)
Accruals 0.0027 (0.52) 0.0025 (0.48) 0.0019 (0.38) 0.0017 (0.34) 0.0030 (0.59)
Intercept 0.0043 (0.90) 0.0041 (0.87) 0.0034 (0.69) 0.0041 (0.84) 0.0033 (0.69)
Adj R2 1.4% 1.5% 1.1% 1.1% 2.0%
Panel B: Measures of downgrade strategies and information environment
Rating Trigger 0.0021 (1.92)
Recently Downgraded 0.0008 (0.92)
Post-RegFD 0.0021 (1.83)
DLnPIN 0.0007 (1.90)
DLn(a) 0.0008 (1.94)
DLn(l/(a l + 2e)) 0.0022 (1.62)
LnME 0.0007 (2.06) 0.0004 (1.25) 0.0004 (1.25) 0.0005 (1.48) 0.0006 (1.56)
B/M 0.0004 (0.45) 0.0006 (0.89) 0.0005 (0.72) 0.0009 (1.05) 0.0009 (1.01)
12 mo. prior return 0.0061 (3.33) 0.0038 (2.89) 0.0047 (3.19) 0.0042 (2.88) 0.0042 (2.85)
Inst. Own. 0.0006 (0.10) 0.0014 (0.29) 0.0007 (0.14) 0.0002 (0.04) 0.0002 (0.03)
Volatility 0.0630 (0.88) 0.0773 (1.37) 0.0685 (1.20) 0.0957 (1.44) 0.0967 (1.47)
Accruals 0.0052 (0.77) 0.0022 (0.42) 0.0023 (0.45) 0.0017 (0.29) 0.0014 (0.23)
Intercept 0.0080 (1.30) 0.0045 (0.93) 0.0035 (0.73) 0.0071 (1.27) 0.0073 (1.33)
Adj R2 2.1% 0.8% 1.0% 1.2% 1.3%
This table reports regression analysis of abnormal short interest on downgrade activity for the sample of downgraded firms. The
dependent variable is abnormal short interest (ABSI) in month t 1. Panel A examines measures of downgrade severity. BBB,
Multinotch, Surprise, and AcrossClass are indicator variables equal to one if: the rating before the downgrade is BBB, the
downgrade is more than 2 notches, the pre-event 12-month abnormal return is positive and CAR(1, 1) is negative, the rating
change is from one letter class to the other, respectively. Panel B examines measures of downgrade strategies and the infor-
mation environment. Post-RegFD is an indicator variable equal to one if the downgrade occurred after the adoption of Regu-
lation FD. Recently downgraded is an indicator variable equal to one if the firm experienced a downgrade within the previous
12 months. PIN is the probability of informed trade, a is the probability of an information event, and (l/(a l + 2e)) represents
the intensity of informed trading when an information event occurs. D Represents changes between the most recent quarter
year and the prior quarter. Rating trigger is an indicator variable designating whether the firm has a ratings-based performance
pricing agreement in its bond covenants in the most recent quarter. The control variables are defined as follows. LnME is the
natural log of market cap the month before the event. B/M is the book-to-market ratio the month before the event. 12 mo. prior
return is the cumulative abnormal returns over the previous 12 months prior to the event month. Inst is institutional ownership
at the most recent quarter end. Volatility is the standard deviation of residual returns from a market model estimated over the
one year ending 1 week before the rating announcement. Accruals are the total operating accruals from the most recent fiscal
year-end. Regression t-Stats (in parentheses) are calculated with 2-way clustered standard errors by firm and year.
which the announcement returns are not negative also provide a useful falsification sample (i.e., we do
not expect higher short selling before those events).
In these tests we control for a firm’s size, book-to-market ratio, momentum, institutional ownership,
residual return volatility, and total accruals. Institutional ownership proxies for the supply of lendable
shares, since borrowing to short is easier when institutional ownership is high (D’Avolio, 2002; Nagel,
2005). Volatility is used to control for limits to arbitrage. Short sellers face higher arbitrage risk when
volatility is high (Duan et al., 2010). Volatility is the standard deviation of residual returns from a market
model estimated over the one year ending 1 week before the rating announcement. Total accruals from
the most recent fiscal year end are included to control for fundamentals that short sellers use to build
their positions (Desai et al., 2002). It is defined as earnings before extraordinary items minus cash flow
from operations minus cash flow from investments, deflated by average total assets.
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Table 2, Panel A reports the results of these regressions specified in Eq. (1) for the 1463 downgrade
events. Some firms have more than one downgrade event during our sample period, so we calculate
the t-stats using 2-way clustered standard errors by firm and year. In columns (1) through (4), we in-
clude one variable related to downgrade surprise or severity, in addition to the control variables. These
tests indicate that, among downgraded firms, abnormal short interest is higher for firms downgraded
to speculative grade, firms downgraded multiple notches, downgrades across rating classes, and
downgrades that are a surprise. In column (5) we include all of the downgrade interaction variables
simultaneously, and three of the four downgrade interaction variables are significant. Overall, these
results indicate that short sellers actively trade for reasons specific to a rating downgrade, even when
controlling for well-known determinants of short interest. We also conduct a falsification test, using
downgrades that are not a ‘‘surprise’’ (i.e., the announcement return for the downgrade is not nega-
tive) and we find no significant abnormal short selling levels for these firms (tabulated results avail-
able upon request). This evidence shows short sellers are effective at predicting downgrades which are
profitable and avoiding those which are not.
In Fig. 3, we graphically depict abnormal short interest prior to BBB downgrades. This figure con-
firms the importance of the speculative grade threshold. The increase in ABSI for BBB downgrades
starts about 4 or 5 months before the downgrade, with a substantial difference one month prior. These
results indicate that short sellers not only focus more on these downgrades, but also they are able to
time the BBB downgrade more effectively than other downgrades. This result is difficult to reconcile
with a non-ratings explanation, such as an equity fundamentals story.
Next, we examine various indicators that may be used by short sellers around downgrades, and
how the information environment might affect downgrade-related short selling. In Panel B of Table 2,
we show results from multivariate regressions that include additional interactions designed to help
understand why short selling is higher before a downgrade. These regressions are specified as de-
scribed in Eq. (1), but instead of a credit rating factor (CRFactor), we include a variable related to
the information-related downgrade strategies. We first consider a strategy that makes use of potential
biases induced by rating-based loan covenants. Kraft (2011) shows that rating agencies give more
favorable ratings adjustments to borrowers with rating-based performance pricing agreements in
their bond covenants (to keep them from triggering rating-based covenants). We examine whether
short sellers recognize the implications of this rating bias and target those firms. We identify firms
subject to ratings-based debt pricing using corporate loan and bond information from Thompson Reu-
ters LPC’s DealScan database. We match the DealScan data to the sample where the firm is identified
as the issuer and the year falls between the issue date and scheduled maturity date. DealScan’s per-
formance pricing file provides detailed pricing adjustments that may be triggered contingent upon
changes in certain financial criteria while the debt is outstanding, including the firm’s credit rating
(Chava and Roberts, 2008). Using DealScan’s performance pricing information, we create an indicator
variable to identify firms subject to any debt pricing structure tied to its credit rating. We find that in
Fig. 3. Abnormal short interest around downgrades: BBB downgrades versus all other (non BBB) downgrades.
j.jfi.2014.02.005
our downgrade sample abnormal short selling prior to the downgrade is higher among firms with
rating triggers in their bond covenants as shown in Table 2B. This result is consistent with the idea
that short sellers identify firms whose ratings are biased favorably. Similarly, one could also interpret
these results to indicate that short sellers target firms who will be hurt most by a ratings downgrade.
Given momentum in rating downgrades documented by Altman and Kao (1992) and Lando and
Skodeberg (2002), we next consider the subsample of firms that that had a rating downgrade in the
12 months preceding the current downgrade. Informed short sellers might make use of this ratings
momentum to identify firms that are more likely to be downgraded. The result in column (2) of
Table 2B shows that ABSI one month prior to a downgrade is higher for the firms that experienced
a downgrade in the prior 12 months, but the coefficient is not statistically significant. In untabulated
results, when we use the average ABSI over the 12 months prior to the downgrade as the dependent
variable in this regression, we find statistically significant evidence that short sellers do react to past
downgrades. These results provide modest evidence that downgrade momentum contributes to the
relationship between short selling and subsequent downgrades.
If identifying future downgrades requires superior information processing skills, then the informa-
tion environment may affect the ability of short sellers to anticipate downgrade events. We create a
dummy variable indicating the time after the passage of Regulation Fair Disclosure (RegFD) on October
23, 2000. RegFD prohibits selective disclosure of non-public information from firms to security profes-
sionals (e.g., equity analysts). However, RegFD excludes rating agencies, such that rating agencies con-
tinue to be allowed to receive non-public information.14 Jorion et al. (2005) find that the information
content of rating downgrades increased after the passage of RegFD, reflecting this information advantage
for ratings agencies. Similarly, we propose that if short sellers are informed investors trading around rat-
ing downgrades for profit, they should undertake this strategy more following passage of RegFD.15 The
positive and significant coefficient on the RegFD coefficient in Column (3) of Table 2B confirms this. This
result provides additional evidence in favor of a ratings-specific interpretation for the relationship be-
tween short selling and rating downgrades.
Another strategy short sellers might implement with respect to information processing is to make
use of changes in adverse selection measures to identify firms likely to be downgraded. Odders-White
and Ready (2006) show that future rating changes can be predicted using recent changes in adverse
selection. We adopt the approach of Odders-White and Ready (2006) to test whether short sellers
use adverse selection prior to rating downgrades. Specifically, we regress ABSI from the month before
a ratings downgrade on the change in adverse selection over the prior quarter. To proxy for adverse
selection, we estimate the probability of informed trade (PIN) measure of Easley et al. (1996), and
its decomposition into specific parameters, similar to Odder-White and Ready.16 We find evidence that
short sellers use adverse selection information when forming their strategies. In particular, for our sam-
ple of downgraded firms, ABSI increases prior to a downgrade when the probability of informed trading
(PIN) increases, and when the probability of an information event (a) increases. These coefficients are
significant at the 10% level. These results are reported in columns (4) and (5) of Table 2B, and highlight
another channel by which short selling is related to future downgrades.17 The evidence in this section
shows a number of ratings specific channels that are associated with higher short selling before a down-
grade. We conclude that short sellers anticipate rating downgrades, specifically due to the downgrade
itself.
14
Recent SEC regulations (in 2010) however have sought to remove this exemption.
15
We also perform a univariate difference-in-difference test for the full sample of rated firms around the passage of RegFD. We
find that ABSI for downgraded firms is significantly higher post-RegFD than pre-RegFD, but there is no difference in ABSI around
RegFD implementation for firms that are not downgraded.
16
Following the methodology of Odders-White and Ready (2006, Table 9), in addition to using the change in the natural
logarithm of PIN, we also decompose PIN into its input parameters, a, l, and e, and use changes in the natural logarithm of a, the
probability of an information event, and changes in the natural logarithm of (l/(a l + 2e)), the intensity of informed trading given
the occurrence of an information event.
17
Our results are not only driven by adverse selection however. In untabulated Probit regression results among all rated firms,
ABSI predicts subsequent downgrades even after controlling for adverse selection measures.
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Table 3
Abnormal short interest and downgrade prediction.
No downgrades Downgrades Total

Panel A: High ABSI = 1 if ABSI P 90th percentile
Non-High ABSI
Frequency 110,868 14,289 125,157
Percent of non-high ABSI observations 88.58% 11.42%
High ABSI
Frequency 12,182 1,811 13,993
Percent of high ABSI observations 87.06% 12.94%
Total 123,050 16,100 139,150
88.43% 11.57% 100%
Chi-squared statistic 28.62 p-Value 0.0001
Estimate StdErr Prob

Panel B: Probit regression of downgrade indicator on ABSI
Intercept 3.166 0.117 0.00
ABSI 26.947 2.979 0.00
LnME 0.056 0.012 0.00
B/M 0.044 0.007 0.00
Momentum 1.723 0.063 0.00
DD/TA 0.312 0.202 0.12
DROA 1.284 0.291 0.00
Test Chi-square Pr > ChiSq
likelihood ratio 1901.67 0.00
score 2463.22 0.00
Wald 1955.33 0.00
This table examines abnormal short interest and downgrade prediction for the full sample of all rated firms. Panel A investigates
whether short selling predicts rating downgrades by grouping all firm months into four cells based on a two-way classification:
whether the amount of abnormal short interest is high or low, and whether the firm month is identified as having downgrades
in that month. A firm-month is put into the high abnormal short interest (ABSI) group if the firm’s abnormal short interest in
that month is above the 90th percentile of ABSI in the cross-section of firms for that month. Panel B reports results from a
multivariate probit regression of the downgrade indicator variable on ABSI and other control variables. ABSI is the mean
abnormal short interest over the prior 12 months. D/TA is long-term debt over total assets. ROA is earnings before extraordinary
items over total assets. D Represents changes between the most recent fiscal year and the prior fiscal year.
4.1.2. Short selling and downgrade predictability

In this section, we directly explore whether short selling predicts subsequent downgrades gener-
ally for the full sample of rated firms. To examine this, we test the relationship between abnormal
short interest and the occurrence of a future downgrade for all rated firms that have short interest
data. Table 3 reports these results.
First, we assign each firm-month to one of four categories, according to whether or not the firm had
high abnormal short interest in a given month (defined as above the 90th percentile), and whether or
not the firm was downgraded in the subsequent 12 months. Karpoff and Lou (2010) implement a sim-
ilar identification scheme.18 The 2 2 matrix in Panel A of Table 3 displays the frequency of firm-
months for each of the four categories. As expected, we see a higher concentration of firm-months along
the non-downgraded dimension, since most firms are not downgraded in a given 12 month period. More
importantly, the concentration of firm-months that have both high short interest and a subsequent
downgrade appears to be higher than random. For any given 12-month period, 11.57% of firms are down-
graded, but among the high short interest category, that percentage is 12.94%. A Chi-squared test rejects
the null hypothesis that the short interest and downgrade categories are not related. This test indicates
that short interest is a predictor of subsequent downgrades generally, among the full sample of rated
firms.
18
We conduct these tests using a 95th percentile cutoff as well, and the results are similar.
j.jfi.2014.02.005
Fig. 4. Abnormal short interest and subsequent monthly rating change. This figure shows abnormal short interest (ABSI) sorted
by whether or not the firm was downgraded in the subsequent month, and sorted into quintiles based on the subsequent
monthly return net of downgrade announcement effect.
Next, we sort firms into two groups based on whether or not they are downgraded in the following
month, and then sort (within group) into five quintiles based on the subsequent monthly return. The
subsequent return is net of the announcement return for the firms that are downgraded. Fig. 4 displays
these results. For all five return quintiles, ABSI is much higher for the group of firms that are down-
graded in the following month. The difference in ABSI across downgrade groups is significant for four
of the five quintiles. This result supports our previous finding that short selling predicts subsequent
downgrades, independent of subsequent non-downgrade related returns.19
Finally, we estimate a probit model by regressing a downgrade indicator variable on ABSI over the
prior 12 months. The regression controls for other variables that have been shown to be related to
downgrades. The results of the probit regression are in Panel B of Table 3. The estimate for ABSI is sta-
tistically significant, confirming that ABSI significantly improves the fit of the model. This is econom-
ically meaningful. Specifically, the marginal effect of an increase in ABSI from the 25th percentile to
the 75th percentile (holding all other variables constant) is associated with a 0.14% increase in the
probability of a downgrade. This marginal increase in ABSI represents 14% of the unconditional prob-
ability of a downgrade (1.0%). This result provides evidence that lagged short interest is incrementally
informative about subsequent downgrades, beyond what is conveyed by other conditioning variables.
Overall, results in this subsection suggest that short sellers are able to predict downgrades.20
4.2. Short selling and changes in default risk
At this point, we have established that short selling is significantly higher before a rating down-
grade (H1), short selling is related to measures of downgrade severity, and short selling helps to pre-
dict future downgrades for all rated firms. While the results of Table 2B indicate that short selling prior
to downgrades may be related to the information environment, we have not yet identified any chang-
ing bond fundamentals that short sellers may use to anticipate the forthcoming downgrade. Credit rat-
ings are a relative opinion about the general creditworthiness of an issuer, and the probability of
default is the single most important factor in this assessment (Standard and Poor’s (2011)). In this sec-
tion, we examine whether short sellers target firms that have had a large increase in the likelihood of
default that might then correspond with a downgrade of their credit rating (H2).
19
The high levels of ABSI for the highest return quintile is surprising. One potential explanation is that short sellers target high
volatility situations that can produce extreme returns in either direction. Regardless, the objective of this figure is to show that
abnormal short interest is significantly higher before downgrades independent of non-downgrade related returns.
20
We also instrument abnormal short interest with an options availability dummy variable and find that abnormal short interest
is only marginally significant (10% level). Kecskés et al. (2013) proposes the changes in short selling restrictions due to RegSHO can
serve as a (more exogenous) instrument for short selling because it affects short selling but not downgrades. We find that the
instrumented abnormal short selling is not significant with this instrument. These tests suggest that although higher short interest
predicts a rating downgrade, the short interest itself does not directly cause the downgrade.
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Table 4
Changes in default risk and abnormal short selling.
Dep. var. Full sample Subsample: Downgraded over

next 12 months
HighDDEFt,t+11 HighDDEFt,t+11
Coef. t-Stat Coef. t-Stat
Panel A: Regression of high change in default risk on lagged ABSI and prior downgrades
Intercept 0.072 (24.74) 0.067 (2.90)
HIABSIt 1 0.048 (6.27) 0.078 (3.87)
LAGDNGt1,t12 0.004 (0.33) 0.009 (0.75)
Adj R2 0.28% 0.76%
DNGt+1,t+12 No DNGt+1,t+12 Difference (t-Stat)

Panel B: Level of ABSIt based on high change in default risk (P90th percentile) and subsequent downgrades
HighDDEFt1,t12 0.0044 0.0008 0.0036
(3.72)
Non-HighDDEFt1,t12 0.0008 0.0001 0.0007
(2.86)
Difference 0.0036 0.0007
(t-stat) (3.73) (3.25)
Dep. var. HIABSIt

Coef. t-Stat
Panel C: Regression of High Level of ABSI, on change in default risk and subsequent downgrades
Intercept 0.107 (39.50)
DDEFt1,t12 0.013 (2.89)
DNGt+1,t+12 0.015 (1.34)
DNGt+1,t+12 DDEFt1,t12 0.045 (4.15)
Adj R2 0.16%
This table looks at the relationship between changes in default risk and abnormal short selling around credit rating downgrades
for the full sample of rated firms. Panel A regresses an indicator variable for a high change in default risk (above 90th
percentile), High DDEF, on an indicator variable for a downgrade in the prior 12 months and an indicator variable for high ABSI
(above 90th percentile) in the previous month. Default risk is measured using the model of Campbell et al. (2008). Panel A
presents results for the full sample of rated firms and the subsample of firms that were downgraded over the subsequent
12 months. Panel B shows the average level of ABSI for four groups based on whether or not the firm had a high increase in
default risk (DDEF) over the prior 12 months (above 90th percentile), and whether or not the firm was downgraded in the
subsequent 12 months. Panel C regresses an indicator variable for high ABSI (above 90th percentile) in a given month on the
change in default risk over the prior 12 months, an indicator variable for a downgrade in the subsequent 12 months, and an
interaction between the change in default risk and the downgrade dummy. Regression t-stats are calculated with 2-way
clustered standard errors by firm and year.
We follow the approach of Cheng and Neamtiu (2009) to create a measure of ratings accuracy that
compares credit rating changes against changes in default risk implied by bankruptcy prediction mod-
els. Our hypothesis is that short sellers can anticipate the forthcoming downgrade because they can
predict or understand changes in the probability of default. In other words, short sellers identify firms
whose ratings have not been adjusted to reflect changes in the likelihood of default (thus the rating is
more likely to be inaccurate). We use the model of Campbell et al. (2008) as our proxy for default risk,
but we use others for robustness as well.21 We then compare levels of short interest with changes in
default risk, both for all rated firms and for firms that are subsequently downgraded. Results are provided
in Table 4.
21
Specifically, we calculate a firm’s CHS score each month using the specification of Mansi et al. (2012, p. 40). We then calculate
the change in this score over a 12 month horizon as our proxy for a change in default risk (DDEF). For robustness, we also use a
distance to default measure based on the structural model of Merton (1974). We report results from the CHS model due to the
findings of both Campbell et al. (2008) and Mansi et al. (2012) that the CHS model generally outperforms the distance to default
measure when measuring distress risk.
j.jfi.2014.02.005
Our first test examines whether abnormally high short selling is able to predict future increases in
default risk. We create indicator variables for firms whose abnormal short interest is in the highest
decile in a given month (HIABSI) and for firms whose change in default risk is in the highest decile over
a 12 month window (HighDDEF). We regress the indicator variable for a large increase in default risk
on the lagged variable for high ABSI. We also control for downgrades that occurred during the prior
12 months (LAGDNG) to account for any abnormal short interest surrounding prior rating downgrades.
The regression specification is as follows:
HighDDEF t;tþ11 ¼ a þ b1 HIABSIt1 þ b2 LAGDNGt1;t12 þ e ð2Þ
The results in Panel A of Table 4 show that firms with abnormally high short interest subsequently
have large increases in their probability of default. We find the same relationship, and the magnitude
is stronger, for the subsample of firms that are downgraded in the next 12 months. These results indi-
cate that abnormally high short selling predicts future increases in default risk, and the effect is larger
for firms that are subsequently downgraded.
Our next two tests examine whether short sellers are able to understand prior changes in default
risk in advance of rating downgrades. In Panel B of Table 4, we compare levels of ABSI for firms that are
downgraded interacted with changes in default risk in the 12 months prior to the downgrade. We per-
form a two-way sort to create four groups based on whether or not a firm had a high change in default
risk (above 90th percentile) over the prior 12 months, and whether or not a firm was downgraded in
the subsequent 12 months. We then calculate the average level of ABSI for each of these four groups.
We find that short interest is particularly high for firms that are subsequently downgraded and that
have also experienced significant changes in default risk in the 12 months prior to the downgrade. This
level of short interest is significantly higher than the cases in which the firm was subsequently down-
graded but did not have a change in default risk, as well as the cases in which the firm had a significant
change in default risk but was not downgraded. So short sellers are able to identify the firms that both
have a significant change in default risk and that are most likely to get downgraded as a result.
In Panel C of Table 4, we regress an indicator variable based on whether a firm falls into the high
ABSI decile in the current month on the change in default risk (DDEF) over the prior 12 months, an
indicator variable for whether the firm is downgraded in the subsequent 12 months (DNG), and an
interaction term between the change in default risk and the subsequent downgrade dummy. The
regression specification is as follows:
HIABSIt ¼ a þ b1 DDEF t1;t12 þ b2 DNGtþ1;tþ12 þ b3 ðDDEF t1;t12 DNGtþ1;tþ12 Þ þ e ð3Þ
The coefficient estimate on the interaction term is the largest in magnitude of the three explanatory
variables, and significant at the 5% level. These regression results confirm the results of the two way
sort analysis in Panel B. Short sellers target firms that have increases in default risk that are likely to be
downgraded as a result.
Overall, the tests in this section identify significant relationships between changes in default risk,
high short selling, and rating downgrades. These results support the hypothesis that short sellers
anticipate rating downgrades because they can predict or understand changes in default risk. The rat-
ing downgrade is the culminating event that leads to the negative equity returns, allowing short sell-
ers to profit from their superior information.
4.3. Profitability of short selling around downgrades
In this section, we test the implications of H3 by examining the profitability of short selling strat-
egies before rating downgrades. One way to examine profitability is to compare the short selling that
takes place during each of the 12 months prior to a rating downgrade that is in excess of a baseline
‘‘normal’’ level of short interest, and calculate the subsequent returns for that abnormal short interest.
Cumulating the returns over this 12 month period, we find that short sellers obtain abnormal returns
of approximately 7% prior to a downgrade. Fig. 5 depicts the returns to the abnormal short selling over
those twelve months, with the spike in the last month a result of the downgrade itself. Some of this
return is perhaps generated by fundamental investing independent of the rating downgrade; however,
j.jfi.2014.02.005
Fig. 5. Profitability from short position prior to a downgrade. This figure shows the market adjusted returns to a portfolio that
short sells firms that are subsequently downgraded 12 months from portfolio formation date. The returns are computed based
on the level of short interest in the twelve months leading up to the downgrade.
Table 5
Profitability to high ABSI portfolios around credit rating downgrades.
Unconditional Conditional on subsequent downgrade

DNGt+1 No DNGt+1 Difference
(NoDNG DNG)
at+1 (%) t-Stat at+1 (%) t-Stat at+1 (%) t-Stat at+1 (%) t-Stat
Panel A: Risk-adjusted returns (at+1) to HIGH ABSIt portfolios based on subsequent downgrade
High ABSIt 0.46 (2.64) 2.35 (1.60) 0.18 (0.70) 2.53 (1.80)
Panel B: Risk-adjusted Returns (at+1) to High ABSIt portfolios based on prior changes in default risk and subsequent downgrade
HighDDEFt1,t12 2.17 (3.16) 6.49 (2.52) 0.15 (0.15) 6.34 (2.13)
Non HighDDEFt1,t12 0.30 (1.37) 0.14 (0.16) 0.57 (1.88) 0.72 (0.79)
Difference 1.87 (3.01) 6.63 (2.66) 0.43 (0.49) 7.06 (2.42)
This table reports profitability to short seller strategies prior to a credit rating downgrade. Panel A shows the risk-adjusted
returns (alphas) to portfolios of high ABSI firms (highest decile ABSI in prior month), conditioned on whether or not a firm
receives a downgrade in the following month. Panel B shows the risk-adjusted returns (alphas) to portfolios of high ABSI firms
based on prior change in default risk. Each month, firms in the highest decile of ABSI are sorted into deciles based on the change
in default risk (DDEF) over the prior twelve months. One portfolio contains high ABSI firms from the highest decile of change in
default risk, and the other portfolio contains high ABSI firms from the other nine deciles of change in default risk. We also report
the alphas when we condition on future downgrades. DNG represents firms that are downgraded during the time period, while
NO DNG represents firms not downgraded. Alphas are calculated using a four factor model including a market factor, a size
factor, a book-to-market factor, and a momentum factor. Regression t-stats are reported in parentheses.
this analysis confirms that the cumulative returns from abnormal shorting prior to a downgrade are
indeed positive and economically significant.
We also examine profitability on a monthly basis. To begin, every month we group all rated firms
into deciles based on abnormal short interest (ABSI), and then partition the high ABSI decile into two
groups: those that are downgraded in the subsequent month and those that are not downgraded in the
subsequent month. Then, we regress the time-series of portfolio returns on market, size, book-to-mar-
ket, and momentum factors. Panel A of Table 5 shows that the high ABSI portfolios earn an abnormal
return (four-factor alpha) of 0.46%. However, we find that the portfolio of high ABSI downgraded
firms generates an abnormal return of 2.35%, while the portfolio of high ABSI non-downgraded firms
produces an abnormal return of 0.18%. The difference in alpha across the two portfolios is a marginally
significant amount of 2.53% (t-stat = 1.80) These results indicate the ability of short interest to predict
low future returns is partially driven by firms that are subsequently downgraded. Thus, much of the
j.jfi.2014.02.005
Table 6
Abnormal stock returns following credit rating downgrades.
Mean (%) t-Stat

Panel A: Abnormal returns for all downgrades
BHAR[1, 3] 1.86 (3.05)
BHAR[1, 6] 1.89 (1.97)
BHAR[1, 12] 2.60 (1.63)
Low ABSI (<10th percentile) High ABSI (P90th percentile)

Mean (%) t-Stat N Mean (%) t-Stat N
Panel B: Abnormal returns by ABSI
BHAR[1, 3] 2.89 (1.36) 138 5.00 (2.13) 137
BHAR[1, 6] 5.11 (1.71) 4.45 (0.89)
BHAR[1, 12] 9.62 (2.13) 1.47 (0.19)
Dep. variable Variable Coef t-Stat Adj R2 (%)

Panel C: Regression of abnormal returns on fitted ABSI from first stage IV
BHAR[1, 3] Intercept ABSI_IV 0.0020 0.0490 (3.39) (3.22) 0.9
This table reports long-run abnormal returns (BHAR) following credit rating downgrades. Firm-specific BHARs are measured as
the buy-and-hold raw returns for the various horizon minus the buy-and-hold return for a benchmark portfolio matched on
size, book-to-market, and momentum. For example, BHAR[1, 3] denotes the abnormal return measured over the horizon from
one month following the downgrade through 3 months following the downgrade. Panel A presents results for all downgrades.
Panel B examines abnormal returns by high and low abnormal short interest (ABSI). High (low) ABSI refers to above 90th (below
10th) percentile of mean ABSI from t 12 to t 1. Panel C regresses BHAR on a fitted value of ABSI (ABSI_IV) from a first stage
instrumental variable regression. The instrument in the first stage is a dummy variable for option availability and RegSHO.
Regression t-stats are calculated with 2-way clustered standard errors by firm and year.
low returns to highly shorted stocks can be explained by future credit rating downgrades. This evi-
dence shows that predicting rating downgrades provides a profitable shorting strategy.
Next, we investigate the profitability of this portfolio strategy including changes in default risk as
an additional variable. Using a similar approach as before, we group all rated firms into ABSI deciles
each month and focus on the high ABSI decile. We partition this decile into two portfolios, one with
high changes in default risk over the prior 12 months (top decile), and another that contains firms
without high changes in default risk. The abnormal returns (four-factor alpha) generated by these
portfolios are shown in Panel B of Table 5. The high ABSI, high change in default risk portfolio gener-
ates a subsequent monthly abnormal return of 2.17% (t-stat = 3.16), while the other high ABSI
stocks generate an insignificant alpha of 0.30%. When we further condition the high ABSI and high
default risk portfolio based on whether there was a subsequent downgrade in the following
12 months, we find that the negative alpha is concentrated in the firms that are later downgraded.22
The downgraded portfolio has an alpha of 6.49% (t-stat = 2.52), while the non-downgraded portfolio
has an insignificant alpha of 0.15%. The difference in alphas across these two portfolios is significant
(t-stat = 2.13). These results illustrate that a portfolio that short sells stocks with high increases in default
risk is profitable, and this profitability is driven by future downgrades. This provides further evidence of
the link between changes in default risk, short selling, and subsequent downgrades.
4.4. Short selling and price discovery
In this section, we provide evidence in support of H4, that short sellers enhance price discovery in
both the equity market and the bond market around rating downgrades.
22
Since we are also conditioning on large changes in default probabilities in these tests, we use a 12-month period for the
downgrade instead of one month to maintain a sample size that provides meaningful results.
j.jfi.2014.02.005
4.4.1. Short selling and price discovery in the equity market

Dichev and Piotroski (2001) find that negative abnormal returns persist after credit rating down-
grades for as long as a year following the downgrade. They conclude that the post-announcement drift
reflects an underreaction to the downgrade, suggestive of pricing inefficiencies. Table 6, Panel A shows
results replicating their study, with post-announcement BHARs for several time horizons following a
credit rating downgrade. Consistent with Dichev and Piotroski (2001), we find evidence of underper-
formance following downgrades, although the magnitudes we document are smaller in some cases. In
this section, we further investigate the relationship of short selling to this post-downgrade return
drift. Specifically, we test whether short selling mitigates this post-downgrade drift.
Diamond and Verrecchia (1987) argue that short selling provides an important market function by
incorporating news into prices more quickly. Recent empirical research suggests that short sellers
contribute to the price discovery process by enhancing price efficiency (for example, Karpoff and
Lou (2010) find that short sellers mitigate mispricing prior to announcements of financial miscon-
duct). Similarly, we investigate whether short sellers provide a comparable role in a new setting, rat-
ing downgrades. While we have previously documented that short sellers profit from pre-identifying
those downgrades that have large negative announcement returns, here we are examining whether
short sellers actually have a diminishing impact on the stock price reaction to downgrades. These re-
sults are not mutually exclusive, especially considering the cross-sectional variation in short selling
constraints. In particular, we expect firms with more binding short selling constraints to have greater
post-announcement drift. We examine these questions by testing the impact of pre-announcement
short selling on post-announcement returns.
Panel B of Table 6 shows how abnormal returns following a downgrade vary with short selling
intensity prior to the announcement. We define high (low) short selling intensity as those events with
mean abnormal short interest above the 90th percentile (below the 10th percentile) in the 12 months
prior to the downgrade. We find that following a downgrade, negative abnormal returns in the high
short interest intensity group are concentrated in the first three months, while they persist for
12 months in the low short interest intensity group. Downgraded firms with low amounts of pre-
downgrade short selling underperform by 9.62% in the year following the downgrade, compared to
an insignificant 1.47% underperformance for firms in the high ABSI group.23 We also define the high
and low ABSI firms using short selling windows that include the announcement month (e.g., t 12 to
t + 2), and the results are similar (results not reported). These results are consistent with short sellers
helping prices adjust to efficient levels more quickly.
To address concerns about the endogeneity of short interest levels, we use two different instru-
mental variables for ABSI to more formally test the independent effect of ABSI on post-announcement
returns. Following Karpoff and Lou (2010), our first instrument for ABSI is a dummy variable indicating
the availability of options in month t for the firm. This instrument is motivated by the finding that
short selling volume is positively related to the availability of options (Diether et al., 2009), as listed
options reduce the cost of hedging short positions. Our second instrument follows Kecskés et al.
(2013) and uses the implementation of RegSHO.24 We believe these variables meet the exclusion
restriction, since we see no strong economic reason that having options or being a pilot firm would di-
rectly impact post return drift following a credit rating downgrade, except through the short selling
channel we are testing.25 The results from the instrumental variable analysis are shown in Panel C of
Table 6. This panel shows results from a regression of the post-announcement BHAR on the fitted value
from the first stage regression of mean ABSI (over the prior 12 months) on our instruments. For all three
post-event holding periods, the coefficient estimate on the fitted value (ABSI_IV) is positive and signifi-
cant, indicating short selling mitigates negative drift.26 The intercept is negative and significant, showing
23
Despite the large economic difference in returns, this difference is not statistically significant.
24
During RegSHO, the SEC designated certain ‘‘pilot firms’’ that were temporarily exempt from the uptick rule.
25
One might argue that option availability causes firms to be more efficiently priced in general. These results hold with either of
the instruments used on its own.
26
This result is robust to the inclusion of other control variables, such as size, book-to-market, and prior 12 month returns.
However, our measure of ABSI implicitly controls for these variables through our matching procedures.
j.jfi.2014.02.005
Table 7
Abnormal short interest and changes in bond yield spread.
Relative month ABSI (%) t-Stat DSpread (%) t-Stat

Panel A: Average abnormal short interest and change in bond spread preceding downgrades
12 0.22 (2.25) 0.12 (1.23)
11 0.26 (2.51) 0.02 (0.18)
10 0.22 (2.44) 0.09 (1.68)
9 0.22 (2.57) 0.04 (0.80)
8 0.24 (2.46) 0.08 (1.84)
7 0.26 (2.76) 0.02 (0.24)
6 0.37 (3.58) 0.00 (0.04)
5 0.30 (2.84) 0.06 (1.45)
4 0.26 (2.86) 0.03 (0.72)
3 0.46 (4.21) 0.14 (3.59)
2 0.45 (3.88) 0.08 (2.18)
1 0.47 (3.66) 0.03 (0.61)
0 0.32 (2.37) 0.07 (1.68)
Model Dep. variable Variable Coef. t-Stat Adj R2 (%)

Panel B: Regressions of change in bond spread and abnormal short interest for downgraded firms
Model 1 DSpreadt Intercept 0.092 (0.76) 3.4
DSpreadt1 0.050 (1.00)
ABSIt1 1.546 (2.17)
AbRett1 0.703 (4.97)
LnMEt1 0.004 (0.41)
B/Mt1 0.017 (0.62)
Instt1 0.046 (0.72)
Volatilityt1 2.588 (1.25)
Accrualst1 0.045 (0.43)
Model 2 ABSIt Intercept 0.005 (1.62) 44.0
DSpreadt1 0.000 (0.04)
ABSIt1 0.644 (18.56)
AbRett1 0.024 (5.98)
LnMEt1 0.000 (0.74)
B/Mt1 0.001 (1.67)
Instt1 0.007 (3.25)
Volatilityt1 0.073 (1.50)
Accrualst1 0.005 (1.42)
This table reports the relation between the change in bond spread (DSpread) and abnormal short interest (ABSI) for 234
downgrades with TRACE data during the 12 months leading up to the event month. DSpread is the monthly change in the yield
spread, calculated as the downgraded firm’s yield minus the yield on an index matched by rating and maturity. Panel A displays
the average ABSI and average DSpread by event month. Panel B reports regressions of DSpread on lagged ABSI (Model 1) or ABSI
on lagged DSpread (Model 2). LnME is the natural log of market capitalization. B/M is the book-to-market ratio. Inst is
institutional ownership at the most recent quarter end. Volatility is the standard deviation of residual returns from a market
model estimated over the one year ending 1 week before the rating announcement. Accruals are the total operating accruals
from the most recent fiscal year-end. Regression t-stats are calculated with 2-way clustered standard errors by firm and year.
that without abnormal short interest, post-downgrade drift remains. These results show that short sell-
ers play an important role in price discovery for downgraded firms.
Additionally, we expect firms with more binding short selling constraints to have greater post-
announcement drift. Here, we again use the implementation of RegSHO as an instrument for short sale
constraints because pilot firms face less constraints than control firms. Comparing the returns
between the constrained downgraded firms and the less-constrained downgraded firms, we again find
some evidence that the firms with larger short sale constraints have more negative announcement
returns (0.70%) and exhibit larger return drift (5.5%) in the year following the announcement.27
27
We also use institutional ownership to proxy for short sales constraints because firms with low institutional ownership have
more limited number of loanable shares (Asquith et al., 2005). We again find that the drifts are larger for more constrained firms.
j.jfi.2014.02.005
Together these results show that short sellers’ ability to improve price discovery is enhanced when they
face less binding constraints.
4.4.2. Short selling and price discovery in the bond market

Our results suggest that equity short sellers anticipate credit rating downgrades. Bond traders
might be similarly informed and also trade in anticipation of credit events. Several papers find
evidence that bond prices move in advance of credit rating downgrades (Grier and Katz, 1976; Hite
and Warga, 1997; Covitz and Harrison, 2003). Other papers also investigate the cross-market relation-
ship between equity returns and bond returns. Kwan (1996) and Downing et al. (2009) show that
stock returns lead bond returns in incorporating firm specific information. Hotchkiss and Ronen
(2002), on the other hand, do not find evidence of such a relationship. Considering our previous results
in the context of these two streams of the literature, we examine whether equity short selling leads
changes in bond yield spreads (or vice versa) prior to downgrades. Since rating downgrades are pri-
marily bond events, bond traders may have a relative informational advantage over equity traders
in this setting.
Panel A of Table 7 reports the average abnormal short interest and the average change in bond
spread (DSpread) in the 12 months prior to a downgrade, for the sample of firms that had both short
interest and bond yield data. DSpread is calculated as the change in a firm’s average monthly bond
yield minus the average monthly yield of a matched benchmark based on the maturity and rating
of the firm the month prior to the downgrade. While short interest is abnormally high in all 12 months
prior to the downgrade, the bond yield spread does not materially widen until three months prior to
the downgrade. This suggests that equity short sellers trade in anticipation of a downgrade earlier
than bond traders.
To formally study the lead-lag relation between abnormal short selling and bond yield change, in
Panel B of Table 7, we regress a firm’s change in bond spread on lagged abnormal short interest (Model
1). Similarly, we regress a firm’s abnormal short interest on lagged change in bond spread (Model 2). In
these pooled regressions, we also include lagged stock returns to control for the relationship between
equity returns and bond returns (Downing et al., 2009), and we cluster the standard errors by firm and
year. To be consistent, we also control for size, book-to-market, institutional ownership, return
volatility, and total operating accruals. In Model 1, DSpread is positively associated with lagged ABSI.
For the average downgraded firm, a one percent increase in lagged abnormal short interest is associ-
ated with a 1.55 basis point increase in bond spread, during the 12 months prior to the downgrade. In
Model 2, there is no statistically significant relationship between ABSI and lagged DSpread. The results
of these two regressions are consistent with the results in Panel A. Kecskés et al. (2013) examine the
relationship between relative short interest and cost of debt financing. While their paper does not
focus on firms that were downgraded, they also find a relationship between short interest and bond
yield spreads.
Although these tests document relative differences in timing between short selling and changes in
bond spreads around rating downgrades, the results do not prove causality between the two. Bond
traders could be reacting specifically to increases in equity short selling, or bond traders could be
slower than short sellers to react to the same information. Regardless, combined with our other
empirical evidence regarding price discovery, these results indicate that short sellers provide a price
discovery role around rating downgrades, and short sellers are able to anticipate rating downgrades
before bond investors.
5. Conclusions
This paper examines whether equity short sellers anticipate bond rating downgrades. We find that
short interest increases prior to rating downgrades, and this result is independent of coincident cor-
porate events (e.g., earnings announcements) and firm fundamentals (e.g., decreasing stock prices).
Abnormal short interest is greater for firms subsequently downgraded to speculative grade from
investment grade, and for firms that receive multi-notch downgrades. Additionally, short interest is
higher for unanticipated downgrades that have pre-event positive returns but surprise negative
announcement returns. These results are consistent with informed trading by short sellers prior to rat-
j.jfi.2014.02.005
ing downgrades. Short sellers also seem to be trading around downgrades more since the passage of
Regulation FD, reflecting the increased impact of rating changes following that legislation.
Anecdotal and empirical evidence suggests that credit rating agencies are sometimes slow to react
to new information. Our results add to this evidence by illustrating the ability of short sellers to pre-
dict rating downgrades, and possibly even exploit inaccuracies in the ratings process. We show that
short sellers start to build up their positions several months ahead of a downgrade, and short interest
contains incremental information for predicting rating changes beyond other known factors. Short
sellers also seem able to understand changes in default risk for a firm that are correlated with rating
downgrades. We also find evidence that short sellers specifically target firms that may have inaccurate
or biased ratings, and use adverse selection to their advantage when forming their trading strategies.
Thus, our findings suggest that abnormal short interest can be a useful tool for assessing credit risk on
a more timely basis. Finally, we demonstrate that short sellers provide a useful market function, facil-
itating the timely incorporation of information into market prices. Stock underperformance following
downgrades is significantly reduced when short selling is higher prior to the downgrade, and abnor-
mal short interest leads widening bond spreads prior to rating downgrades.
Acknowledgments
The authors would like to thank S. Viswanathan (editor), two anonymous referees, Don Autore, Da-
vid Chapman, Jonathan Karpoff, Marc Lipson, Adam Reed, and seminar participants at Boston College,
Florida State University, Goethe University, Miami University, the University of Arizona, the University
of Virginia, the University of Washington and the 2011 RMA-UNC Academic Forum for Securities
Lending Research for comments. We also thank Daniel Wade for research assistance. This paper
was previously circulated under the title ‘‘Do Equity Short Sellers Anticipate Bond Rating Down-
grades?’’. Henry acknowledges financial support from the Frank H. Jellinek, Jr. Endowed Assistant Pro-
fessor Chair in Finance. Any remaining errors are the responsibility of the authors.
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J. Finan.

Intermediation xxx (2014) xxx–xxx

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Equity short selling and bond rating downgrades

⇑ Corresponding author. Fax: +1 513 529 6992.

H4. Short selling around bond downgrades contributes to price discovery.

4.1. Short selling and anticipation of downgrades

4.1.1. Abnormal short selling prior to downgrades

Relative month (1) (2) (3)

Variable (1) (2) (3) (4) (5)

No downgrades Downgrades Total

Estimate StdErr Prob

4.1.2. Short selling and downgrade predictability

4.2. Short selling and changes in default risk

Dep. var. Full sample Subsample: Downgraded over

DNGt+1,t+12 No DNGt+1,t+12 Difference (t-Stat)

Dep. var. HIABSIt

HighDDEF t;tþ11 ¼ a þ b1 HIABSIt1 þ b2 LAGDNGt1;t12 þ e ð2Þ

HIABSIt ¼ a þ b1 DDEF t1;t12 þ b2 DNGtþ1;tþ12 þ b3 ðDDEF t1;t12 DNGtþ1;tþ12 Þ þ e ð3Þ

4.3. Proﬁtability of short selling around downgrades

Unconditional Conditional on subsequent downgrade

Mean (%) t-Stat

Low ABSI (<10th percentile) High ABSI (P90th percentile)

Dep. variable Variable Coef t-Stat Adj R2 (%)

4.4. Short selling and price discovery

4.4.1. Short selling and price discovery in the equity market

Relative month ABSI (%) t-Stat DSpread (%) t-Stat

Model Dep. variable Variable Coef. t-Stat Adj R2 (%)

4.4.2. Short selling and price discovery in the bond market

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