Lower Credit Ratings Research Articles

Pricing Credit Default Swaps with Option-Implied Volatility

Using the industry benchmark CreditGrades model to analyze credit default swap (CDS) spreads across a large number of companies during the 2007–09 credit crisis, the authors demonstrate that the performance of the model can be significantly improved by calibrating it with option-implied volatility rather than with historical volatility. Moreover, the advantage of using option-implied volatility is greater among companies with more volatile CDS spreads, more actively traded options, and lower credit ratings.

Government Guarantees and Bank Risk Taking Incentives

This paper analyzes the effect of the removal of government guarantees on bank risk taking. We exploit the removal of guarantees for German Landesbanken which results in lower credit ratings, higher funding costs, and a loss in franchise value. This removal was announced in 2001, but Landesbanken were allowed to issue guaranteed bonds until 2005. We find that Landesbanken lend to riskier borrowers after 2001. This effect is most pronounced for Landesbanken with the highest expected decrease in franchise value. Landesbanken also significantly increased their off-balance sheet exposure to the global ABCP market. Our results provide implications for the debate on how to remove guarantees.

Audit Prices, Credit Ratings: S&P-100

This study tests the hypothesis that the companies which have lower credit ratings are charged higher audit fees or the companies which have higher credit ratings pay lower audit fees. The hypothesis is based on the assumption that these price differentials should be observed given Credit ratings and financial ratios in a stable audit market. For this study, data from S&P-100 is used. The companies which composes S&P-100 index have shown that the difference between audit fees is derived from credit ratings.

Public debt financing, ownership structures and bankers on boards: evidence from Japan

This article provides new insights on determinants that affect the allocation of bankers to firm boards by focusing on the benefits and costs they bring to the boards. Using data on Japanese firms during the period 2003-2007, we find that firms with lower credit ratings have higher proportions of bankers on their boards to gain easier access to bank credit. In contrast, firms with large shareholders face potential costs arising from conflicts of interest between large shareholders and banks, and accept fewer bankers on their boards. The results indicate that availability of public debt financing and ownership structures are important factors affecting the allocation of bankers to firm boards.

Economic Policy and the Constitutionality of Asset Securitization

Under US laws, all forms of asset securitization are unconstitutional. Securitization of many types of assets (loans, credit cards, auto receivables, intellectual property, etc.) has become more prevalent, particularly for financially distressed companies and companies with low or mid-tier credit ratings. This article focuses on securitization as it pertains to asset-backed securities and mortgage-backed securities, and analyzes critical legal and corporate governance issues.

Adaptation strategies of the poorest farmers in drought-prone Gujarat

A literature survey indicates that farmers can adopt many strategies to cope with climate change. On the basis of 160 interviews in Gujarat, India, this paper examines which coping strategies are used by farmers and how government policies influence farmer behaviour. This paper concludes that the impressive drought relief framework focuses more on ex post, short-term responses and does not take into account the potential impacts of climate change or the actual experiences of the poorest farmers. Further, some farmers are able to access the variety of policy assistance that the state offers, but credit and insurance schemes remain out of reach for farmers with low credit ratings and large rain-fed farms.

Corporate Environmental Management and Credit Risk

This study analyzes environmental management and its implications for bond investors. Poor environmental practices influence the credit standing of borrowing firms through the legal, reputational, and regulatory risks associated with environmental incidents. We devise environmental performance measures based on information from an independent rating agency, and provide evidence that these measures explain the cross-sectional variation in credit risk for a sample of 582 U.S. public corporations between 1995 and 2006. Our findings suggest that firms with environmental concerns pay a premium on their cost of debt financing and are assigned lower credit ratings. In contrast, firms with proactive environmental engagement benefit from a lower cost of debt financing. The results are robust to numerous controls for company and bond specific characteristics, alternative model specifications, and industry membership.

Rating Agency Reputation, the Global Financial Crisis, and the Cost of Debt

It has been a puzzle why foreign firms obtain credit ratings by global rating agencies such as S&P or Moody’s rather than from their home country’s rating agencies even though the global raters typically assign lower credit ratings when these foreign firms issue bonds in their home currencies. In addition, unlike firms in the U.S., foreign firms are not required to obtain ratings from the SEC-sanctioned Nationally Recognized Statistical Rating Agencies (NRSROs). We investigate this puzzle with new 3,525 yen-denominated plain vanilla bonds issued in Japan during 1998-2009 and find that bonds rated by at least one global agency can, on average, result in yields that are 11-14 bps lower than those rated by only Japanese rating agencies. However, during the 2007-2009 financial crisis, Japanese issuers which used S&P and Moody’s actually faced yields that were 14-19 bps higher, thus negating the prior advantage of obtaining a bond rating from a global rating firm, after controlling for other factors. This suggests that the credibility and reputation of the global rating agencies such as S&P and Moody’s have declined following public disclosure of these firms’ problems associated with the subprime mortgage securitization process. In addition to the greater size and longer maturity of the bond issue, we find that Japanese firms with more financial leverage, greater information asymmetry, higher levels of equity ownership by foreigners, poor financial performance, and greater systematic risk are more likely to seek ratings from Moody’s or S&P rather than Japanese rating agencies.

Efficiency and credit rating in Taiwan banking: data envelopment analysis estimation

In this article, we use the data envelopment analysis to measure the efficiency of banks before and after credit rating is taken into consideration and we also employ the Malmquist Productivity Index to measure the total factor productivity changes from 2001 to 2003. The results are as follows: (1) There is a positive relationship between the efficiency scores and credit rating, and thus, the credit rating can be a representative to evaluate the performance and quality of a bank; (2) We use the Wilconxon two-sample test of nonparametric statistic to test the influences of credit rating. The empirical result shows that the credit rating is proven to influence the efficiency of banks; (3) The efficiency scores improve in both investment grade (above tw BBB−) and speculation grade (under tw BBB−), when credit rating is taken into consideration. The empirical results show that the efficiency scores of banks with a high credit rating improved relatively more when compared to banks with a lower credit rating; (4) In this research we also adopt the Malmquist index to observe the productivity and efficiency changes from year to year. We obtain results whereby the improvement of efficiency may be influenced greatly both from pure technical and scale efficiency changes.

Are Junk Bonds Junk?

This paper employs Sharpe ratio and information ratio to investigate if junk bonds with lower credit ratings command higher excess returns than premium bonds with higher credit ratings after the subprime crisis under “synergy negative convexity”. Our empirical results reveal that: (1) Corporations with lower credit ratings have higher excess returns in equity values, as proxies for excess returns in bond prices, than those with higher credit ratings even in different sectors, (2) Because of credit rating changes, the downgraded corporations have excess returns in equity values as proxies for excess returns in bond prices, regardless if they obtain higher or lower credit ratings initially in the same sector, and (3) Indices of equity values and indices of bond prices are used as parameters in estimating if there exist differentiated implied excess returns, of which the high yield indices have higher risk premium than the investment grade indices. The implications of our findings are that the misperception about riskiness of junk bonds before the subprime crisis and the “synergy systematic risk” results in under-demanded and underpriced junk bonds, which lead to higher excess returns. Finally, the higher excess returns obtained by corporations with lower credit ratings, the downgraded corporations, or all high yield indices in (3), are attributed to the ignorance of credit rating agencies in any economic states and risk components even before the subprime crisis.

The Impact of Budget Stabilization Funds on State General Obligation Bond Ratings

This study examines the impact of budget stabilization funds (BSFs) on state general obligation (GO) bond credit ratings. While a number of past empirical papers have examined the effect of various fiscal institutions on state GO bond ratings; to date, BSFs have been largely ignored in the literature. Model estimates show that neither the choice to have a statutory BSF versus a constitutional BSF or the size of a BSF has any apparent impact on credit ratings. However, weak deposit rules are associated with lower credit ratings while weak withdrawal rules are associated with higher credit ratings.

Default Correlations in the Presence of Coskewness and Cokurtosis Between Two Firm Values

The previous studies on coskewness and cokurtosis between assets concentrate on the effects of coskewness and cokurtosis on the returns and prices of financial assets. This paper explores the default correlation in the presence of coskewness and cokurtosis between two firm values. In doing so, we extend the structural model of Merton (1974) to incorporate coskewness and cokurtosis. We can observe some findings as follows. First, there are no significant effects of skewness and kurtosis associated with each individual firm return on default correlation. Second, the lower coskewness (or the higher cokurtosis) is, the larger default correlations are. But we can observe the opposite result for the firms with low credit rating as the maturity gets longer.

Applying Method to the Madness: An Empirical Analysis of California Budget Delays

California is notorious for its budget gridlock. From 1950 to 2008, the budget was adopted late 44 percent of the time. Although short delays have few consequences, delays in passage have become longer in the last two decades leading to more severe consequences, such as a lower credit rating and higher borrowing costs. The purpose of this paper is to systematically analyze late adoptions of the state budget and the factors responsible for them. I employ annual data from 1950 to 2008 and estimate regression models of the length of budget delays, controlling for economic conditions. This study reveals that divided government, party polarization, and revenue volatility, among other factors, prolong delays. Interestingly, budget gridlock is less pronounced in legislative election years when legislators seem to be fearful of voter retribution. I conclude by discussing potential reforms that could help the state avoid budget stalemates in the future.

How Do Credit Rating Agencies Affect Relationship Lending?

Small businesses have long relied upon banks to produce sufficient information to be able to profitably lend to them. In recent years information production has also taken place among information service bureaus, such as Dun and Bradstreet (D&B). There has been some evidence to suggest that these information brokers have allowed small firms to break away from their lending relationships.In this paper, we present a model of how small business loans are analyzed, focusing on the information that is necessary to produce. Based on the insight from that model, we build a multinomial logistical regression model to estimate joint probabilities that a firm with at least one line of credit will fall into certain categories of D&B credit rating and secured/unsecured line of credit. From this multinomial logistic regression model, we derived conditional logistic regression, where the probability the line of credit is secured is conditioned upon the credit rating category.We find that the length of a relationship with the line of credit lender is only a significant predictor of collateral for firms with lower credit ratings, consistent with the theory that relationships are needed to overcome informational opacity. In fact, it appears from the set of logistic regressions run, that the significance of the length of the lending relationship to the granting of unsecured lines of credit reported in earlier research is driven solely by firms with lower credit ratings. The length of the relationship was not significant in assessing the probability of secured lines of credit for those with the highest credit rating.

The Effect of Monetary Policy on Credit Spreads

We analyze the effect of monetary policy on yield spreads between corporate bonds with different credit ratings over the business cycle. We use futures contracts to distinguish between expected and unexpected changes in the Fed funds target rate and several indicators to distinguish between different phases of the business cycle. In line with the predictions of imperfect capital market theories, we find that yields on corporate bonds with low credit ratings widen (narrow) with respect to those with high credit ratings following an unexpected increase (decrease) in the Fed funds target rate during recession periods. Several tests suggest that our results are robust to outliers, potential endogeneity problems, empirical specification, control variables, countercyclical risk premium in futures, and alternative definitions of credit spreads and economic conditions.

Sovereign Risk and Strategic Debt

The world economy is engulfed in an economic crisis. In an attempt to avert a repetition of the Great Depression, governments across the globe have borrowed heavily to finance fiscal stimulus packages. Rising debt levels have put the credit ratings of many countries, including those in the developed world, at risk. A lower credit rating increases the cost of borrowing. Whilst it thus decreases leverage in fiscal policy, it also has, as this article will show, a positive side effect: since borrowing is costly, a lower credit rating decreases a government's incentives to increase the deficit shortly before elections to enhance its electoral stakes (resulting in a so-called political budget cycle). This proposition derives empirical support from 25 countries between the years 1980 and 2008.

Does Customer Satisfaction Matter to Investors? Findings from the Bond Market

This article examines whether customer satisfaction is associated with key metrics from corporate bond markets—namely, credit ratings and cost of debt financing. The authors draw on theory in marketing and finance to predict how customer satisfaction should be associated with both measures. To test the hypotheses, they employ the American Customer Satisfaction Index (ACSI) database of more than 150 publicly traded firms during the period from 1994 to 2004. The empirical work controls for factors that are known to influence the bond market, such as firm profitability and risk, as well as potential unobservable factors. The findings indicate that firms with lower customer satisfaction exhibit lower credit ratings and higher debt costs—financial consequences of customer satisfaction not previously observed. The results also suggest that the association between ACSI and cost of debt is attenuated by the inherent level of risk faced by the firm.

Estimating the Demand for Credit Card: A Regression Discontinuity Approach

Using the credit card application data provided by a major credit card issuer, we estimate the demand for credit card using a regression discontinuity method. Our method exploits a unique feature of the credit card solicitation campaign design, i.e. credit issuer gives consumers different interest rate based on some cutoff points in consumers' credit score. This discontinuity in the interest rate offers allows us to obtain a reliable estimate of the effect of the interest rate on consumers' credit demand. We find that consumers' demand for credit card is near unit elasticity. The demand elasticity is estimated at -1.14. In addition, consumers with better credit rating are more responsive to interest rate than consumers with lower credit rating. We also find that, without controlling for the endogeneity of contracts, a regression model would give biased estimates.

International Perspectives on Foreign Bond Markets

While the domestic bond markets of Asia-Pacific have grown considerably since the Asian Financial Crisis of 1997, it is clear that they remain undeveloped relative to the region’s weight in the world economy. This paper adds to the policy debate on this issue by proposing that in order to encourage further development in these markets, regulators should make them more accessible to foreign borrowers.We offer insights into the nature and mechanics of foreign bond issuance in domestic markets by investigating the key characteristics of 3,132 foreign bonds issued in 14 countries (other than the US) between 1928 and June 2009. We find that the foreign borrowers that tap domestic markets are overwhelmingly high credit quality and comprise sovereigns, supranationals, and major financial institutions. Although there is a significant corporate presence, usually by non-bank financial institutions, issuance by this sector tends to have a shorter maturity and generally carry lower credit ratings. There is a preference for simple fixed-rate payment structures, which can then be swapped into the currency and coupon type of choice using currency and interest rate derivatives. On the whole, the long-term viability of foreign bond markets appears to be linked to the presence of highly liquid foreign exchange and derivatives markets that facilitate risk management and transformation, enabling regulation that facilitates cooperation with market participants, the presence of benchmark issues, and competitive pricing between alternate market segments.

The Puzzling Peso

In the past decade, some observers have noted an unusual aspect of the Mexican peso's behavior: during periods when the U.S. dollar has risen (fallen) against other major currencies such as the euro, the peso has risen (fallen) against the dollar. Very few other currencies display this behavior. In this paper, we attempt to explain the unusual pattern of the peso's correlation with the dollar by developing some general empirical models of exchange rate correlations. Based on a study of 29 currencies, we find that most of the cross-country variation in exchange rate correlations with the dollar and the euro can be explained by just a few variables. First, a country's currency is more likely to rise against the dollar as the dollar rises against the euro, the closer it is to the United States and the farther it is from the euro area. In this result, distance likely proxies for the role of economic integration in affecting exchange rate correlations. Second, and perhaps more surprisingly, a country's currency is more likely to exhibit this unusual pattern when its sovereign credit rating is more risky. This may reflect that currencies of riskier countries are less substitutable in investor portfolios than those of better-rated countries. All told, these factors well explain the peso's unusual behavior, as Mexico both is very close to the United States and has a lower credit rating than most industrial economies.