Credit Rating Downgrades Research Articles

Recent evidence on political brinkmanship and Treasury yields

PurposeThis paper aims to analyze how political brinkmanship impacted Treasury yields during the debt ceiling debate in 2015. The results show that the resignation of the House Speaker John A. Boehner caused a significant decrease in Treasury bill yields of one- and three-month maturities. The authors robust analysis indicates that these lower yields have saved US taxpayers several billion dollars in extra tax expenses. This paper provides evidence that lack of political brinkmanship can be very advantageous for the taxpayers. This has considerable implications for lawmakers in this post-election year.Design/methodology/approachThe authors examine the differences in yields between equal maturity short-term Treasury securities and commercial paper using t-tests, non-parametric tests and a robust regression model based on earlier empirical studies.FindingsThis study provides evidence indicating that between September 25, 2015, and up to October 30, 2015, relatively lower Treasury yields resulted from the lack of political brinkmanship, and this has saved the US taxpayers several billion dollars in interest expenses in 2015.Research limitations/implicationsThe study showed that lower yields will result from a lack of political brinkmanship, and this resulted in savings of several billions of dollars in interest payments. Considering that both the White House and Congress will be controlled by the same political party, this gives lawmakers a unique opportunity to have less acrimonious debt ceiling debates. The limitation of the study is that it does not consider the impact on foreign exchange markets and other factors which could play a major role.Practical/implicationsUnlike earlier scenarios where default risk increased, followed by credit rating downgrades, there was a quiet confidence this time about a quick resolution. Markets were stable, and this allowed money market participants to invest more confidently even when an upcoming debt ceiling debate is on. Corporations that invested additional cash in money markets for short-term could do it more confidently at that time without fear of default or interest rate risk which could potentially harm the market value of their investments.Practical/implicationsIt implies that there will be lower taxpayer costs because of debt ceilings and avoidance of shutdowns of the federal government. It also implies that there could be more confidence in the dollar.Originality/valueSeveral earlier studies have examined Treasury default caused by political brinkmanship. This is the first study to examine an event where political brinkmanship appeared possible and then suddenly dissipated in a single day. Political brinkmanship is bad news because it increases taxpayer interest burden as seen from several of the studies above. Therefore, it should be considered good news if no disagreement is evident. This argument serves as our motivation for this paper. As an increase in the chances of default causes an increase in the yield of Treasury bills as earlier studies showed, a decrease in the chance of default caused Treasury bill yields to be that much lower based on the results of this study.

Qualitative Corporate Disclosure and Credit Analysts' Soft Rating Adjustments

While academics have extensively studied quantitative models of credit risk, far less is known about credit analysts’ behind-the-scenes adjustments to the ratings generated by their models. Using both dictionary-based and topic modeling approaches, we examine whether and how credit analysts use borrowers’ qualitative disclosures to extract information pertaining to credit risk in making their assessments. We decompose publicly-available ratings into qualitative factors (soft adjustments) and quantitative factors (hard adjustments) and find that credit analysts’ soft adjustments, but not the hard adjustments, reflect information in borrowers’ qualitative disclosures. Our results further indicate that the association between firms’ qualitative disclosures and soft adjustments increases with the intensity of the rating agency’s reliance on public disclosure. We also examine whether analysts’ use of credit risk-relevant information from borrowers’ qualitative disclosures render ratings more credible and thus informative. We find that the credit rating downgrades of borrowers that provide more qualitative disclosures are more informative than those that do not; however, the increase in informativeness diminishes after the Dodd-Frank Act, when the legal liability for credit rating agencies increased.

Risk-adjusted inside debt

Compensation theory holds that executive aggression is related to both the level and riskiness of inside debt. However, previous researchers only have examined the level of inside debt. We provide an inside debt metric that is conceptually superior to previously used metrics as it incorporates the riskiness of inside debt. For the overall sample, our metric provides similar fit to prior metrics but is theoretically superior. The relation between our risk-adjusted inside debt metric and corporate conservatism is modestly better for non-investment grade firms, firms experiencing credit rating downgrades, and firms with high credit risk. The results tentatively support that managers are concerned with the risk-adjusted value of their inside debt, i.e., the inside debt adjusted by its default probability and expected recovery rate. Based on our findings for U.S. firms, we expect our metric to offer more explanatory power for economies wherein inside debt is very risky.

The Real Effects of Credit Ratings: Evidence from Corporate Asset Sales

What is the relative contribution of credit rating downgrades on financial distress and managerial discipline? We find that firms are more likely to conduct asset sales following a credit rating downgrade, particularly so if firms indicate the purpose is to use the proceeds to pay down outstanding debt or to raise cash. We find a smaller or no effect if the sale is motivated by concentrating on core assets or involves the sale of a loss making or bankrupt operation. Shareholder wealth effects of the asset sale following a credit rating downgrade are consistent with the event being perceived by the market as a successful mechanism by the seller to mitigate financial distress caused by the downgrade and where buyers benefit from discounted fire-sale prices and when the assets have greater asset redeployability. Asset sales following a downgrade are more likely to involve segments that are the most liquid, generate the least current cash flows, and have the highest growth opportunities. Peer-based performance, intrafirm performance, or relatedness to core activities, do not explain the choice for which segments are divested. Our results suggest that firms respond to credit rating downgrades with asset sales in an attempt to reduce financial distress and that downgrades, at the margin, exacerbate financial distress rather than induce managerial discipline.

Why do firms hold cash? Evidence from Korean stock listings

Corporate governance and the availability of external financing can be important determinants of corporate cash holdings. In this research, in line with Opler et al. (1999), the authors find that Korean firms’ cash holdings are affected by firm-level characteristics including firm size, leverage, market to book, cash flow ratio, net working capital, and cash flow volatility in addition to corporate governance. Rather than agency-prone, the authors can ascribe the increase in cash holdings to the precautionary corporate demand for cash (Campbell et al., 2001). The authors also report that operating risks stemming from cash flow volatility, unavailability of external finance, credit rating downgrades, etc., may be associated with precautionary corporate demand for cash. Lastly, it is documented that corporate governance proxied for by block and/or insider ownership stakes is inversely associated with corporate cash holdings. Keywords: demand for money, corporate governance, corporate cash holding. JEL Classification: G39, E41, G34

Do Credit Ratings Incorporate Business Linkages Along the Supply Chain?

This paper investigates whether credit ratings incorporate business linkages along the supply chain. We first document that a supplier’s bankruptcy risk is significantly associated with its major customer’s bankruptcy risk, thereby leading to a positive association between the credit ratings of the supplier and its major customer. However, the association between a supplier’s and its major customer’s credit rating changes is asymmetric. A supplier’s credit rating change is only positively associated with its major customer’s credit rating change when the customer has experienced a credit rating downgrade, but not when the customer has undergone an upgrade. This asymmetric effect is stronger when the customer-supplier relation lasts for a long time and when the customer is the largest customer of the supplier. We attribute this effect to the asymmetric payoff functions of the creditors, who focus on protecting downside risk rather than generating upside returns. Overall, our paper provides evidence that the customer’s credit worthiness influences the supplier’s credit ratings, suggesting that the debt market can be affected by the product market through the customer-supplier relations.

Corporate financing and anticipated credit rating changes

Firm circumstances change but rating agencies may not make timely revisions to their ratings, thereby increasing information asymmetry between firms and the market. We examine whether firms time the securities market before a credit rating agency publicly reveals its decision to change a firm’s credit rating. Using quarterly data, we show that firms adjust their financing structures before credit rating downgrades are publicly revealed. Specifically, firms on average increase their debt financing by 1.29 % before the disclosure of a rating downgrade, and this increase is due to the issuance of debt rather than the repurchase of equity. In contrast, firms do not take significant financing actions before credit rating upgrades.

Corporate Financing in Anticipation of Credit Rating Changes

Firm circumstances change but rating agencies may not make timely revisions to their ratings, thereby increasing information asymmetry between firms and the market. We examine whether firms time the securities market before a credit rating agency publicly reveals its decision to change a firm's credit rating. Using quarterly data, we show that firms adjust their financing structures before credit rating downgrades are publicly revealed. Specifically, firms on average increase their debt financing by 1.29% before the disclosure of a rating downgrade, and this increase is due to the issuance of debt rather than the repurchase of equity. In contrast, firms do not take significant financing actions before credit rating upgrades.

Euro crash risk

Abstract We identify crucial events during the European sovereign debt crisis and investigate their impact on the euro currency. In particular, we analyze how specific announcements related to vulnerable eurozone member states, European Central Bank (ECB) actions, and credit rating downgrades affect the value and the crash risk of the euro. We proxy the appreciation and depreciation of the euro by its abnormal foreign exchange (FX) rate returns with respect to 35 currencies. The crash risk of the euro is proxied by the conditional skewness of the FX rate return distribution with respect to the same currencies. We find that the market reacts positively to news related to countries under EU/IMF rescue umbrella. We discover that ECB actions on average result in a euro depreciation on the day of the announcement reflecting obvious concerns of market participants, but the effect is partly reversed the day after. Our analysis also shows that sovereign and corporate credit rating downgrades tend to lead to a depreciation of the euro and, more importantly, to an increase of the euro crash risk. Interestingly, we find that specific announcements about Greece on average do not substantially affect the euro exchange rate directly; however, it does have an overall significant effect on the euro crash risk, imposing a substantial risk for the stability of the common currency in the eurozone.

Credit contagion and competitive effects of bond rating downgrades along the supply chain

This study investigates credit risk effects of credit rating downgrades on downgraded firms’ intra-industry rivals (horizontal relation), suppliers and customers (vertical relation). Using event study approach, we analyze credit default swap (CDS) spread changes for downgraded firms’ rivals, suppliers and customers. The result shows that rivals and suppliers experience significant credit spread increases during bond rating downgrades. Suppliers suffer from vertical credit contagion only conditioning on occurrence of horizontal credit contagion (increasing credit risk among intra-industry rivals). When horizontal credit competitiveness happens (decreasing credit risk among intra-industry rivals), customers appear to have vertical credit competitive effects.

Global banking, global crises? The role of the bank balance-sheet channel for the transmission of financial crises

We examine whether shocks to leveraged creditors with cross border holdings have an incidence on debtor countries׳ risk of suffering financial turmoil. We construct a new proxy of shocks to international banks׳ balance-sheets using credit ratings and the structure of their international assets. This allows us investigating the effect of (foreign) bank balance-sheet shocks on domestic financial turmoil in a large sample of 146 developed and emerging economies from 1984 to 2011. Our proxies of shocks towards bank balance-sheets are strong predictors of systemic banking crises in their debtor countries. Confirming these results, bilateral bank flows significantly decrease when creditor banks׳ assets are hit by negative shocks, as measured by credit rating downgrades from third-party countries. Short-term liabilities towards global banks appear to increase roll-over and funding risks, thereby amplifying the impact of shocks to foreign lenders’ balance-sheets. Domestic banking sectors vulnerabilities, such as illiquid assets and a low deposit-asset ratio, are found to increase crisis contagion risk. In contrast, a high level of global liquidity attenuates the transmission of shocks to international banks׳ assets to debtor countries.

What determines outstanding corporate debt mix? Evidence from fractional multinomial logit estimation

ABSTRACTThis study employs the fractional multinomial logit setting proposed by Papke and Wooldridge (1996) to examine factors driving the choice among nonbank private (144A) debt, bank loans and public debt made by 988 nonfinancial firms during 1993–2007. We document that the majority of firm-level factors have persistent effects on corporate outstanding debt mix across economic conditions. We also highlight the importance of macroeconomic variables on firms’ borrowing decisions as predicted by Diamond (1991). Finally, we document a substitution effect among debt financing sources due to credit rating downgrades, which is inconsistent with Rauh and Sufi (2010).

Euro Crash Risk

We identify crucial events during the European sovereign debt crisis and investigate their impact on the euro currency. In particular, we analyze how specific announcements related to vulnerable Eurozone member states, European Central Bank (ECB) actions, and credit rating downgrades affect the value and the crash risk of the euro. We proxy the value changes of the euro by its abnormal foreign exchange (FX) rate returns with respect to 35 currencies. The crash risk of the euro is proxied by the conditional skewness of the FX rate return distribution with respect to the same currencies. We find that the market reacts positively to news related to countries under the European and International Monetary Fund (IMF) rescue umbrella. We discover that ECB actions on average result in a euro depreciation on the day of the announcement reflecting obvious concerns of market participants, but the effect is partly corrected the day after. Our analysis also shows that sovereign and corporate credit rating downgrades tend to lead to a depreciation of the euro and, more importantly, to an increase of the euro crash risk. Interestingly, we find that specific announcements about Greece on average do not substantially affect the euro exchange rate directly, however, it does have an overall significant effect on the euro crash risk, imposing a substantial risk for the stability of the common currency in the Eurozone.

Natural gas price uncertainty and the cost‐effectiveness of hedging against low hydropower revenues caused by drought

AbstractProlonged periods of low reservoir inflows (droughts) significantly reduce a hydropower producer's ability to generate both electricity and revenues. Given the capital intensive nature of the electric power industry, this can impact hydropower producers’ ability to pay down outstanding debt, leading to credit rating downgrades, higher interests rates on new debt, and ultimately, greater infrastructure costs. One potential tool for reducing the financial exposure of hydropower producers to drought is hydrologic index insurance, in particular, contracts structured to payout when streamflows drop below a specified level. An ongoing challenge in developing this type of insurance, however, is minimizing contracts’ “basis risk,” that is, the degree to which contract payouts deviate in timing and/or amount from actual damages experienced by policyholders. In this paper, we show that consideration of year‐to‐year changes in the value of hydropower (i.e., the cost of replacing it with an alternative energy source during droughts) is critical to reducing contract basis risk. In particular, we find that volatility in the price of natural gas, a key driver of peak electricity prices, can significantly degrade the performance of index insurance unless contracts are designed to explicitly consider natural gas prices when determining payouts. Results show that a combined index whose value is derived from both seasonal streamflows and the spot price of natural gas yields contracts that exhibit both lower basis risk and greater effectiveness in terms of reducing financial exposure.

The Influence of Credit Ratings on Capital Structure

We find partial support for the Credit Rating-Capital Structure hypothesis: firms make a larger effort to avoid a potential credit rating downgrade; but not to achieve an upgrade. Credit ratings provide information to investors, and therefore changes in credit ratings affect markets. Financial markets punish firms which have a downgrade in credit ratings via covenant restrictions. Firms near a potential credit downgrade make larger capital structure changes in capital structure decisions. However, the extent of the effect of credit ratings to capital structure choice may vary across the types of companies. This article examines to what extent credit ratings affect the choice of capital structure in business segments. The paper identifies the magnitude of capital structure changes vary for financial firms and for utility companies, is greater for non-investment (i.e. speculative) grade firms due to a certification effect, and the magnitude varies over both time and across the credit spectrum, and is related to credit spreads.

Risk-Adjusted Inside Debt

Compensation theory holds that executive aggression is related to both the level and riskiness of inside debt. However, previous researchers only have examined the level of inside debt. We provide an inside debt metric that is conceptually superior to previously used metrics as it incorporates the riskiness of inside debt. For the overall sample, our metric provides similar fit to prior metrics but is theoretically superior. The relation between our risk-adjusted inside debt metric and corporate conservatism is modestly better for non-investment grade firms, firms experiencing credit rating downgrades, and firms with high credit risk. The results tentatively support that managers are concerned with the risk-adjusted value of their inside debt, i.e., the inside debt adjusted by its default probability and expected recovery rate. Based on our findings for U.S. firms, we expect our metric to offer more explanatory power for economies wherein inside debt is very risky.

Insider Trading and Credit Rating: Evidence from the US.

In this paper I examine the relationship between credit rating and insider trading of 301 firms from 2000-2006 for S&P 500 Index firms. I argue that changes to the firm credit rating may increase (decrease) informed trading activities. This investigation is essential since insiders with private information may trade opportunistically to maximise profit before such information reaches the stock market. Credit rating downgrade (upgrade) has the potential of changing the capital structure of the firm and hence may affect firm performance in the long run. Such change also affects the level of risk tolerance for equity and debt holders. The results found that higher level of opportunistic trading activities of insiders are strongly associated with weaker credit rating firms. I found also that insider trading activities are associated with changes of firm credit rating in the future. These findings suggest that insiders trade opportunistically to capture market mispricing. Further, firms with stable credit rating appear to have limited insider trading activities. These findings suggest that firm risk do influence trading behaviour of insiders in the capital market.

European CLOs: The Devil Is in the Details

The collateralized loan obligation (CLO) product will always embody the tension between, on the one hand, managers continually striving for more flexibility in the documentation and, on the other hand, the concerns and sensitivities of investors. And both cases are acted out against the backdrop of the ebb and flow of rating agency criteria and regulation. This can result in a surprising number of differences in the documentation from deal to deal, some of which are considered in this article, which focuses on European CLOs. With regard to regulation, practice has evolved concerning which party to a CLO transaction acts as the risk-retention holder; the method of risk retention is not uniform; and there are divergent approaches to Volcker Rule compliance. There may be unexpected variance in the commercial terms of notes issued by CLOs, such as quarterly and semi-annual payment conventions, non-payment-of-interest covenants, note holder quorum and resolution requirements, repricing options, and trading restrictions triggered by credit rating downgrades. Restrictions on underlying assets vary in such areas as the reinvestment period; the flexibility to invest in categories such as “cov-lite” transactions; limitations in categories such as the amount of first-lien, last-out transactions; the percentage of assets in the portfolio originated by the manager; and the ability of the manager to extend the maturity of the notes. Manager provisions vary and have evolved in such areas as incentive fees, key-person clauses, and the roles of secondary managers. <b>TOPICS:</b>CLOs, CDOs, and other structured credit, legal/regulatory/public policy, developed

Investigating Intraday Interdependence Between Gold, Silver and Three Major Currencies: the Euro, British Pound and Japanese Yen

In this study, the interrelationship between major exchange rate returns (namely EUR/USD, GBP/USD, JPY/USD) and precious metal returns (gold and silver) is examined using a vector autoregressive model in a multivariate asymmetric GARCH framework on the intraday frequency. Our findings indicate a unidirectional volatility transmission from the majority of our currencies (EUR/USD, GBP/USD) to precious metals. The sluggish response of silver volatility to currency volatility shocks permits implementation of intraday profitable strategies, providing implications against market efficiency when analyzing intraday data. In the case of the British pound and Japanese yen, a volatility shock affects silver volatility more than gold volatility. Crisis events such as the Greek default and US credit rating downgrade reduce significantly the correlation of EUR/USD and gold/silver. The covariance between EUR/USD and silver increases after a volatility shock in EUR/USD. The same happens with JPY/USD and silver. These findings are important for portfolio managers and monetary authorities.

The Reaction of European Credit Default Swap Spreads to the U.S. Credit Rating Downgrade

Using data consisting of Credit Default Swap (CDS) spreads, this study examines CDS spreads for nearly all European countries surrounding the August 5th, 2011 Sovereign Credit Rating downgrade of the United States. While U.S. CDS spreads remained at relatively normal levels, we find a surge in European CDS spreads during the ten-day period surrounding the U.S. downgrade. At their highest level during this ten-day period, CDS spreads were nearly 25 percent higher than normal indicating that the CDS market perceived that the U.S. downgrade dramatically affected the likelihood of default in European countries. We find that European countries with the smallest GDP per capita and countries that had not recently been downgraded had the largest increase in CDS spreads.