Issuer Credit Quality Research Articles

Credit risk, debt overhang, and the life cycle of callable bonds

Abstract We show that callable bonds have both higher yields and lower market prices than matched non-callable bonds of the same issuer-time, reflecting the value of call features to issuers and investors. This “value of callability” as well as the inclusion and the exercise of call rights are jointly determined by issuer credit quality. Critically, our agency-based theoretical and empirical analyses show that callability reduces debt overhang in corporate mergers. Our results help explain the value and increasing prevalence of callable bonds in credit markets.

Emerging market debt and the COVID‐19 pandemic: A time–frequency analysis of spreads and total returns dynamics

AbstractWe apply wavelet analyses to study the impact of COVID‐19 pandemic on the performance of emerging market bonds, in both investment grade and high yield ranges of creditworthiness. Our results show varying level of coherence ranging from low, medium and high between the Coronavirus Media Coverage index and the price moves of the emerging market USD‐denominated debt. We attribute the intervals of low coherence levels to the diversification potential during a systemic pandemic such as COVID‐19 of investments in bonds issued by developing economies. We document differences in patterns exhibited by various indices describing behaviour of option‐adjusted spreads and total returns as a function of credit quality of issuers form emerging market economies. We report well‐defined zones of the regime switching between the lead and lag roles of the emerging market bonds vis‐à‐vis the media coverage.

Do Rating Agencies Benefit from Providing Higher Ratings? Evidence from the Consequences of Municipal Bond Ratings Recalibration

ABSTRACTWe ask whether credit rating agencies receive higher fees and gain greater market share when they provide more favorable ratings. To investigate this question, we use the 2010 rating scale recalibration by Moody's and Fitch, which increased ratings absent any underlying change in issuer credit quality. Consistent with prior research, we find that the recalibration allowed the clients of Moody's and Fitch to receive better ratings and lower yields. We add to this evidence by showing that the recalibration also led to larger fees and to increases in the market shares of Moody's and Fitch. These results are consistent with critics’ concerns about the effects of the issuer‐pay model on the credit ratings market.

Pay for Praise: Do Rating Agencies Get Paid More When They Provide Higher Ratings? An Examination of the Consequences of the Recalibration of Municipal Debt

We ask whether credit rating agencies receive higher fees and gain greater market share when they provide more favorable ratings. To investigate this question, we use the 2010 rating scale recalibration by Moody's and Fitch, which increased ratings absent any underlying change in issuer credit quality. Consistent with prior research, we find that the recalibration allowed the clients of Moody's and Fitch to receive better ratings and lower yields. We add to this evidence by showing that the recalibration also led to larger fees and to increases in the market shares of Moody's and Fitch. These results are consistent with critics’ concerns about the effects of the issuer‐pay model on the credit ratings market.

The information value of credit rating withdrawals

Moody's (2011) withdraws credit ratings when a debt issuer files for bankruptcy, does not provide sufficient information to the rating agency, or is merged with another firm. When ratings are withdrawn, there is less information available regarding an issuer's credit quality. We examine the stock and bond price reactions following announcements of Moody's credit rating withdrawals and find that the announcements of rating withdrawals result in significant and negative stock and bond price reactions for issuers with withdrawn ratings. Issuers that continue to have an S&P or Fitch's rating following a Moody's rating withdrawal experience a smaller stock price decrease than those without credit ratings from any rating agency. Moreover, we find that liquidity risk increases significantly around rating withdrawal announcements because we observe a sharp decrease in bond trading volume and frequency.

The Economics of Solicited and Unsolicited Credit Ratings

This paper develops a dynamic rational expectations model of the credit rating process, incorporating three critical elements of this industry: (1) the rating agencies' ability to misreport the issuer's credit quality, (2) their ability to issue unsolicited ratings, and (3) their reputational concerns. We analyze the incentives of credit rating agencies to issue unsolicited credit ratings and the effects of this practice on the agencies' rating strategies. We find that issuance of unfavorable unsolicited credit ratings enables rating agencies to extract higher fees from issuers by credibly threatening to punish those that refuse to acquire a rating. Also, issuing unfavorable unsolicited ratings increases the rating agencies' reputation by demonstrating to investors that they resist the temptation to issue inflated ratings. In equilibrium, unsolicited credit ratings are lower than solicited ratings, because all favorable ratings are solicited; however, they do not have a downward bias. We show that, under certain conditions, a credit rating system that incorporates unsolicited ratings leads to more stringent rating standards.

No Guaranties: The Decline of Municipal Bond Insurance

The credit crisis that roiled the financial and housing markets in late 2007 and early 2008 resulted in well‐publicized budget challenges for state and local governments. Less visible has been a dramatic change in the bond insurance market, which alters how governments issue long‐term debt. Debt issuance data from Texas are used to model bond insurance premiums and examine utilization following the crisis. The results provide evidence that insurance premiums rose dramatically following the fiscal crisis, even when controlling for widening credit spreads and changes in the underlying credit quality of issuers.

Issuer Credit Quality and the Price of Asset Backed Securities

Following the financial market crisis of the past few years, critics and scholars have identified numerous problems related to all parties associated with securitization, including investors, rating agencies, issuers, underwriters, and borrowers. Some of this research focuses on the rating process itself. Adam Ashcraft, Paul Goldsmith-Pinkham, and James Vickery (2009) show that observable credit fundamentals deteriorated relative to ratings between 2005 and 2007. Efraim Benmelech and Jennifer Dlugosz (2009) find that collateralized debt obligations (CDOs) rated by only one rating agency are more likely both to be downgraded and to suffer more severe downgrades than CDOs rated by more than one agency. Joshua Coval, Jakub Jurek, and Erik Stafford (2009a) point out that ratings of CDOs were highly unreliable due to models that were highly sensitive to even small errors in economic projections or losses and that underestimated the correlation of risks across various debt securities. Other research focuses on the conflicts of interest between parties who participate in the underlying processes of originating and bundling loans and collecting payments from delinquent borrowers. Chris Downing, Dwight Jaffee, and Nancy Wallace (2009) find that some residential mortgage backed securities trade in a market for lemons where originators can use private information to determine which mortgage Issuer Credit Quality and the Price of Asset Backed Securities

The Economics of Solicited and Unsolicited Credit Ratings

This paper develops a dynamic rational expectations model of the credit rating process, incorporating three critical elements of this industry: (i) the rating agencies' ability to misreport the issuer's credit quality, (ii) their ability to issue unsolicited ratings, and (iii) their reputational concerns. We analyze the incentives of credit rating agencies to issue unsolicited credit ratings and the effects of this practice on the agencies' rating strategies. We find that the issuance of unfavorable unsolicited credit ratings enables rating agencies to extract higher fees from issuers by credibly threatening to punish those that refuse to acquire a rating. Also, issuing unfavorable unsolicited ratings increases the rating agencies' reputation by demonstrating to investors that they resist the temptation to issue inflated ratings. In equilibrium, unsolicited credit ratings are lower than solicited ratings, because all favorable ratings are solicited; however, they do not have a downward bias. We show that, under certain conditions, a credit rating system that incorporates unsolicited ratings leads to more stringent rating standards.

Empirical Credit Risk

An empirical model of credit risk is based here on the observed relation between issuer credit quality, measured by yield spreads, and the attribution of issuer bond returns to interest rate changes or the issuer's equity return. High-quality bond returns are largely explained by interest rate changes, while low-quality bond returns are explained primarily by the issuers' equity returns. Intermediate-credit quality bond returns have a substantial bond market-specific component that is unexplained by either interest rate changes or equity returns. The various influences on the bond-equity return relationship allow construction of an exposure model to be used for corporate bond hedging, scenario analysis, and risk forecasting. <bold>TOPICS:</bold> <ext-link>Credit risk management</ext-link>, <ext-link>security analysis and valuation</ext-link>, <ext-link>portfolio theory</ext-link>

Empirical Credit Risk

We describe an empirically motivated model of credit risk based on a study of the relation between returns to corporate bonds, government bonds and equities. Examining almost 200,000 monthly return events spanning 6+ years, we find a clear systematic relationship between issuer credit quality, as measured by its bonds' yield spreads, and the attribution of its bonds' returns to interest rate changes and the issuer's equity return. Returns to high quality bond, with low yield spreads, are largely explained by interest rate changes, while returns to low quality bonds, with large spreads are primarily explained by the issuers' equity returns. Returns to bonds of intermediate credit quality are not significantly explained by either interest rate changes or equity returns, and appear to be attributable only to bond market specific factors. (Explained here does not imply causation, but merely dependence in a regression.) We also find evidence of an agency effect in the weaker correlations between bond returns and positive firm-specific equity returns than between bond returns and equity common-factor returns or between bond returns and negative firm-specific equity returns. Using a heuristic model giving the regression coefficients of the bond return relationship in terms of the level of bond spreads, we describe an improved approach to modeling credit risk for corporate bonds, effectively accounting for correlations induced by market common factors.

Credit Spread Arbitrage in Emerging Eurobond Markets

In the corporate emerging Eurobond fixed-income market there are two main sources of credit risk: sovereign risk and the relative credit quality of issuers of the eurobonds. This article presents a model to estimate, in a one-step procedure, both the term structure of interest rates and the credit spread function of a diversified international portfolio of Eurobonds with different credit ratings. The estimated term structures can be used to analyze credit spread arbitrage opportunities in Eurobond markets. Numerical examples in the Argentinean, Brazilian, and Mexican Eurobond markets illustrate the practical use of the methodology.

The issuer effect on default risk insured municipal bond yields

In this study, an interesting aspect of the secondary market's pricing of the riskiness of insured municipal bonds is examined. Do secondary market investors still consider the underlying intrinsic credit quality of the issuer in pricing insured bonds? Is the pricing of this 'issuer effect' treated equally for both revenue and general obligation bonds? We find that, while the market does not differentiate between equally insured revenue and general obligation bonds, the intrinsic credit quality of the issuer is reflected in the bond issue's quality spread. The results suggest that investors are concerned with the default risk protection of insured municipal bonds regardless of whether they are revenue or general obligation bonds. The market does not perceive insurers to be perfect substitutes for issuers in a risk transfer. Further, the results suggest there is justification for obtaining an agency rating according to issuer credit quality even for insured bonds.

Variations in municipal bond default risk premia by term-to-maturity

A recent study by McInish of the influence of term-to-maturity on municipal bond default risk premia concluded that default risk premia were not invariant with respect to maturity. That study, as well as an earlier one by Robinson, failed to consider the effects of issuer credit quality. Using a large cross-sectional sample of general obligation bonds sold between 1977 and 1980, the influence of issuer credit quality on the relationship between term-to-maturity and default risk premia is investigated. The results indicate that default risk premia were an increasing function of maturity, and that this effect was larger for lower rated bonds.