Incentives, Clienteles, and Information Production: New Evidence from Investor-paid and Issuer-Paid Agency Credit Ratings and Equity Analyst Recommendations

Abstract

We compare the timeliness of the information signals produced by investor-paid credit rating agencies (Egan and Jones), issuer-paid credit rating agencies (Standard and Poor's), and by sell-side equity analysts, and study the predictive power of this information for the bond and equity markets and for firm investment levels. We conjecture that the three information producing intermediaries differ in two important dimensions: first, in their compensation structure, giving rise to differences in their incentives to produce and transmit timely information signals; and second, in their information consuming clientele, giving rise to differences in the aspects of firms' future cash flow distribution on which they focus. We develop testable hypotheses based on the above two differences. Consistent with our hypotheses, we find the following. First, information signals produced by the investor-paid rating agency are the most timely, and anticipates those produced by the issuer-paid agency and equity analysts. Second, while investor-paid agency rating changes have the greatest predictive power for bond yield spreads, equity analyst recommendations have the greatest predictive power for excess stock returns. Third, credit rating changes by the investor-paid rating agency have the greatest predictive power for firms' investment levels.