Impact of Multiple CDO Ratings on Credit Spreads

Abstract

The authors analyze whether multiple ratings for CDO tranches have an impact on credit spreads and examine the various effects with regard to the number of rating agencies involved. Based on a data set of more than 5,000 CDO tranches, the authors calculate index-adjusted credit spreads to isolate the specific credit risk per CDO tranche and find a negative correlation between number of ratings and credit spreads per CDO tranche—i.e., additional ratings are accompanied by lower credit spreads. On the basis of a valuation model, the authors show that multiple ratings are a significant pricing factor and conclude that investors demand an extra risk premium due to information asymmetries between CDO issuers and investors. Any additional rating reveals incremental information to the market and increases transparency with regard to the underlying portfolio’s credit risk. However, the study does not find empirical support for the hypothesis that marginal tranche spread reduction decreases when additional rating agencies are added. Finally, the study finds evidence that second or third ratings by Fitch on average are higher when directly compared with Moody’s and/or S&P ratings per CDO tranche. This finding is in line with existing literature on corporate bonds and indicates a bias also on CDO ratings due to their solicited character.