A behavioral explanation of credit ratings and leverage adjustments

Abstract

We study the effect of firms’ credit rating changes on their leverage adjustments. We consider behavioral (the prospect theory) and firm-related factors to converge the divergent views on firms’ capital structure. Our position is novel and not in the vein of the prior literature. The adjustment speed is insensitive to the credit rating changes for the under-levered firms. For the over-levered firms, being near a credit rating downgrade has a positive effect on the adjustment speed. However, being near a credit rating upgrade does have any impact. Also, a credit downgrade (upgrade) has a positive (negative) impact on the adjustment speeds of the over-levered firms. The over-levered firms that experience a credit downgrade struggle to regain their previous ratings by reducing leverage at a faster rate. In most cases, the firms’ reactions to credit rating changes are in line with the loss aversion aspect of the prospect theory.