Abstract
A rating trigger is a particular type of debt covenant that mandates the borrower to maintain its own credit rating above a certain rating threshold, requiring, in the event of a rating downgrade, the adoption of specific enforceable actions aimed at securing the lender claims from the borrower’s higher risk level. Rating triggers lower the cost of borrowing capital, but when activated, they exacerbate the borrower’s need for liquidity just at the moment when its credit risk is higher, making the borrower’s default more likely to occur. Despite the potential threat posed by rating triggers on debt markets, these contractual devices remain almost unregulated both in the US and in Europe. The purpose of this paper is first to analyse the effects rating triggers can have on overall market risk and second to assess the proliferation of rating triggers among large US and non-US companies in order to establish whether these contractual devices need stricter regulation. The article is divided in two parts. Sections 2 to 5 provide an overview of the different types of triggers and analyse the rationale behind their use in terms of advantages and disadvantages for both issuers and investors. In sections 6 to 9, I perform an empirical analysis by assessing the rating triggers that have been used by Dow Jones Industrial Average Index companies. I then examine the correlation between the use of rating triggers and the companies’ risk profiles by measuring their credit ratings and their Altman’s Z-Scores in order to find out whether triggers are mostly used by risky companies, capable of being impaired by the triggers’ activation and thus posing a threat to market stability. In section 10, I strengthen the analysis by examining whether such correlation also applies to non-US companies which use rating triggers. In section 11 conclusions are drawn suggesting the introduction by US and European regulators of a specific duty to disclose all the rating triggers that listed companies include in bond indentures and in financial contracts every year.
Highlights
There are three main reasons why credit ratings are relevant: first, because investors regard them as reliable and take them into account; second, because the regulators incorporate them in legal rules, forcing financial markets’ actors to comply with them; and because financial contracts make credit rating a parameter that the counterparties have to take into consideration
The lack of transparency of the rating process further complicates the task for investors who want to assess the contribution of an agency”.On the effects of rating actions’ announcements see Hand, J.R.M., Holthausen, R.W., & Leftwich R.W. (1992)
The purpose of this paper is first to analyze the effects rating triggers can have on overall market risk and second to assess the proliferation of rating triggers among large american companies in order to ensure whether these contractual devices need a stricter regulation
Summary
There are three main reasons why credit ratings are relevant: first, because investors regard them as reliable and take them into account; second, because the regulators incorporate them in legal rules, forcing financial markets’ actors to comply with them; and because financial contracts make credit rating a parameter that the counterparties have to take into consideration. Available at SSRN: http://ssrn.com/abstract=1726943; triggers and highlights the consequences they can have on the market; section 6 introduces the empirical part of the study and explains the scope of such analysis; section 7 assesses the diffusion and the magnitude of rating triggers within the sample of companies that have been examined; section 8 analyzes the correlation between the use of rating triggers and credit rating; section 9 examines the correlation between the use of rating triggers and the companies’ Altman Z-Score, regarded as a reliable measure of the companies’ overall stability; section 10 draws the conclusions based on the empirical results and suggests the regulatory action concerning rating triggers that appears to be more appropriate
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