Speculative-grade Ratings Research Articles

A Comparative Analysis of the Investment- and Speculative-Sovereign Credit Ratings

This paper examines the variability of emphasis on sovereign credit ratings (SCRs) issued by three leading credit rating agencies: Moody’s, S&P, and Fitch. Using the sample of 55 countries with observations from year 1998 to 2017, this study reveals a clear variation of emphasis on these determinants in assessing the investment-grade versus speculative-grade rated countries. For the speculative-grade rated countries, only determinants representing the Institutional and Susceptibility to External Event factors matter during the post-global financial crisis (GFC) period. Despite the observed variabilities, there is no evidence to support the argument that the CRAs changed their criteria in SCR determination after the global financial crisis. The seven-determinant model continues to have high predictive power for SCRs of all three leading issuers in a rage of 68 to 71% for investment-grade ratings and 81 to 87% for speculative-grade ratings.

Corporate social responsibility and the term structure of CDS spreads

This paper examines the role of corporate social performance in the CDS market, with a focus on the differential effect conditional on the lengths of time horizons. We find that firm’s strong social performance negatively predicts the slope of CDS term structure, by reducing the long-term credit risk and increasing the short-term credit risk. After controlling for credit ratings in a “path analysis”, we find that the direct effect of social performance remains significant, suggesting that CDS market participants incorporate this information more efficiently than credit rating agencies. Furthermore, the effects of social performance are stronger for firms with speculative-grade ratings, smaller size, or less analyst coverage. Our findings remain robust to alternative proxy for credit term structure based on S&P ratings or to the sample without the 2008 Financial Crisis period.

Credit rating, banks' capital structure and speed of adjustment: A cross-country analysis

Recent studies examining the effects of a credit rating on firms’ capital structure and adjustment of capital structure to target have focused predominantly on non-financial firms, with virtually no attention given to financial institutions. Using an international sample of 391 rated banks from 76 countries, this study examines the effects of credit ratings on the capital structure of banks. We find that, on average, banks near a credit rating upgrade have a higher capital to assets ratio compared to banks not near a rating upgrade. Most systematically important “too-big-to-fail” banks near a credit rating upgrade tend to have lower capital relative to assets than the rest of the banks in our sample. Furthermore, banks downgraded from an investment-grade rating to a speculative-grade rating, on average, hold 1 (3) percentage points less capital relative to assets in the short (long) run. Contrary to studies based on non-financial firms, our results show that credit ratings have relatively little economic effect on the speed at which banks’ capital is adjusted. Our results suggest that while rating agencies exert influences on banks’ capital structure, they are fewer in number and tend to be weaker, compared to those documented in non-financial firms.

Peer firms’ credit rating changes and corporate financing

We find that firms reduce net debt issuance (NDI, hereafter) when industry peers with the same credit rating were downgraded in the previous year, as opposed to an average NDI increase among all firms. This finding is consistent with the considerations of competition and contagion associated with relative strengths and weaknesses in credit quality. The peer effect on NDI reduction is ubiquitous across both speculative- and investment-grade firms, but is particularly strong for small size firms with speculative-grade ratings, and firms operating in concentrated industries, and in times when the economy is in expansion or outside financial crises. We also find that firms reduce leverage when their ratings are lower than the industry average, and that peer firms’ rating effects remain strong even when controlling for the lower-than-average effect.

Corporate Social Responsibility and the Term Structure of CDS Spreads

This paper examines the role of corporate social performance in the CDS market, with a focus on the differential effect conditional on the lengths of time horizons. We find that strong social performance is negatively associated with the slope of CDS term structure, by reducing the long-term credit risk and increasing the short-term credit risk. After controlling for credit ratings in a “path analysis”, we find that the direct effect of social performance remains significant, suggesting that CDS market participants incorporate this information more efficiently than credit rating agencies. Furthermore, the effects of social performance are stronger for firms with speculative-grade ratings, smaller size, or less analyst coverage.

Peer Firms’ Credit Rating Changes and Corporate Financing

We find that firms reduce net debt issuance (NDI, hereafter) when industry peers with the same credit rating were downgraded in the previous year, as opposed to an average NDI increase among all firms. This finding is consistent with the considerations of competition and contagion associated with relative strengths and weaknesses in credit quality. The peer effect on NDI reduction is ubiquitous across both speculative- and investment-grade firms, but is particularly strong for small size firms with speculative-grade ratings, and firms operating in concentrated industries, and in times when the economy is in expansion or outside financial crises. We also find that firms reduce leverage when their ratings are lower than the industry average, and that peer firms’ rating effects remain strong even when controlling for the lower-than-average effect.

Sovereign Credit Rating Mismatches

We study the factors behind split ratings in sovereign credit ratings from different agencies, for the period 1980-2015. We employ random effects ordered and simple probit approaches to assess the explanatory power of different macroeconomic, government and financial variables. Our results show that structural balances and the existence of a default in the last ten years were the least significant variables whereas the level of net debt, budget balances, GDP per capita and the existence of a default in the last five years were found to be the most relevant variables explaining rating mismatches across agencies. For speculative-grade ratings, we also find that a default in the last two or five years decreases the rating difference between S&P and Fitch. For the positive rating difference between S&P and Moody’s for investment-grade ratings, an increase in external debt leads to a smaller rating gap between the two agencies

Debt Maturity Structure and Credit Quality

AbstractWe examine whether a firm’s debt maturity structure affects its credit quality. Consistent with theory, we find that firms with greater exposure to rollover risk (measured by the amount of long-term debt payable within a year relative to assets) have lower credit quality; long-term bonds issued by those firms trade at higher yield spreads, indicating that bond market investors are cognizant of rollover risk arising from a firm’s debt maturity structure. These effects are stronger among firms with a speculative-grade rating and declining profitability, and during recessions.

The Impact of Credit Rating Changes on Capital Structure Decisions: Evidence from Non-Listed Firms in Germany

Changes in corporate credit ratings affect subsequent capital structure decisions. The results for listed companies in our U.S. sample support Kisgen’s (2006, 2009) credit rating-capital structure hypothesis. However, applying a system GMM system approach, the implications of this hypothesis are weakened by our estimates for the speed of capital structure adjustment after credit rating changes. In contrast, publicly listed companies in our German sample are widely independent from changes in their creditworthiness. Similarly, changes in the capital structure and financing choices of high creditworthy privately-held firms in Germany are more or less independent from credit rating changes. At speculative grade rating levels, however, these firms implement financing activities that strengthen their capital structure subsequent to a rating downgrade. Our findings for the speed of adjustment support these results. We find some contradictory patterns for credit rating upgrades at lower rating levels. We conclude that the close relationship of German firms, whether publicly listed or not, to their banks helps them to mitigate else substantial effects of adverse changes in their creditworthiness.

Sovereign Rating News and Financial Markets Spillovers: Evidence From the European Debt Crisis

This paper examines the spillover effects of sovereign rating news on European financial markets during the period 2007-2010. Our main finding is that sovereign rating downgrades have statistically and economically significant spillover effects both across countries and financial markets. The sign and magnitude of the spillover effects depend both on the type of announcements, the source country experiencing the downgrade and the rating agency from which the announcements originates. However, we also find evidence that downgrades to near speculative grade ratings for relatively large economies such as Greece have a systematic spillover effects across Euro zone countries. Rating-based triggers used in banking regulation, CDS contracts, and investment mandates may help explain these results.

Sovereign Rating News and Financial Markets Spillovers: Evidence from the European Debt Crisis

This paper examines the spillover effects of sovereign rating news on European financial markets during the period 2007-2010. Our main finding is that sovereign rating downgrades have statistically and economically significant spillover effects both across countries and financial markets. The sign and magnitude of the spillover effects depend both on the type of announcements, the source country experiencing the downgrade and the rating agency from which the announcements originates. However, we also find evidence that downgrades to near speculative grade ratings for relatively large economies such as Greece have a systematic spillover effects. Rating-based triggers may help explain these results.

Default risk modeling beyond the first-passage approximation: Extended Black-Cox model

We develop a generalization of the Black-Cox structural model of default risk. The extended model captures uncertainty related to firm's ability to avoid default even if company's liabilities momentarily exceeding its assets. Diffusion in a linear potential with the radiation boundary condition is used to mimic a company's default process. The exact solution of the corresponding Fokker-Planck equation allows for derivation of analytical expressions for the cumulative probability of default and the relevant hazard rate. Obtained closed formulas fit well the historical data on global corporate defaults and demonstrate the split behavior of credit spreads for bonds of companies in different categories of speculative-grade ratings with varying time to maturity. Introduction of the finite rate of default at the boundary improves valuation of credit risk for short time horizons, which is the key advantage of the proposed model. We also consider the influence of uncertainty in the initial distance to the default barrier on the outcome of the model and demonstrate that this additional source of incomplete information may be responsible for nonzero credit spreads for bonds with very short time to maturity.

Structural Shifts in Credit Rating Standards

I examine the time series variation in corporate credit rating standards for the period 1985-2007. I report two main findings: (i) There is a divergent pattern between investment grade and speculative grade rating standards during 1985-2002. Investment grade ratings tighten between 1985-2002. In contrast, the speculative grade rating standards loosen during the same period. Consistent with an agency explanation, rating companies assign more issuer friendly ratings to speculative grade credits, where there is substantial growth by the first-time entrants. The loose standards in speculative grade ratings are consistent with widespread criticism of the rating agencies during the Dot-Com crash. However, while the media focused on failure of rating agencies in high profile corporate debacles, the more serious problem was in the speculative grade rating assignments. (ii) There is a sharp structural break in both investment grade and speculative grade standards towards more stringent ratings around 2002. The change in rating levels due to the structural break is both economically and statistically significant. Holding firm characteristics constant, firms experience a drop of 1.5 notches in ratings due to tightening standards between 2002 and 2007. It appears that widespread criticism and threat of regulation led rating agencies to move towards more conservative ratings after the Enron debacle and passage of Sarbanes-Oxley Act.

Structural Shifts in Credit Rating Standards

I examine the time-series variation in corporate credit-rating standards from 1985 to 2007. A divergent pattern exists between investment-grade and speculative-grade rating standards from 1985 to 2002 as investment-grade standards tighten and speculative-grade loosen. In 2002, a structural shift occurs towards more stringent ratings. Holding characteristics constant, firms experience a drop of 1.5 notches in ratings due to tightened standards from 2002 to 2007. Credit-spread tests suggest that the variation in standards is not completely due to changes in the economic climate. Rating standards appear to a ffect credit-spreads. My evidence suggests that loose ratings lead to higher default rates.

Debt Maturity Structure and Credit Quality

We examine whether a firm's debt maturity structure affects its credit quality. Consistent with theory, we find that firms with greater exposure to rollover risk (measured by the amount of long-term debt payable within a year relative to assets) have lower credit quality; long-term bonds issued by those firms trade at higher yield spreads, indicating that bond market investors are cognizant of rollover risk arising from a firm's debt maturity structure. These effects are stronger among firms with a speculative grade rating, declining profi tability, and during recessions.

Do Firms Target Credit Ratings or Leverage Levels?

AbstractFirms reduce leverage following credit rating downgrades. In the year following a downgrade, downgraded firms issue approximately 1.5%–2.0% less net debt relative to net equity as a percentage of assets compared to other firms. This relationship persists within an empirical model of target leverage behavior. The effect of a downgrade is larger at downgrades to a speculative grade rating and if commercial paper access is affected. In particular, firms downgraded to speculative are about twice as likely to reduce debt as other firms. Rating upgrades do not affect subsequent capital structure activity, suggesting that firms target minimum rating levels.

Quality of internal control over financial reporting, corporate governance and credit ratings

Credit rating is a primary determinant of firm cost of debt capital, capital structure, and hence the range of acceptable investment opportunities. Scant research has been conducted thus far on the relation between internal controls and cost of capital, particularly after the 2002 Sarbanes–Oxley Act. However, academic researchers argue that credit ratings may be affected by internal governance mechanisms instituted by firms and that the quality of internal controls is a potential driver of cost of equity capital. This paper examines whether firm credit ratings is associated with the quality of internal control over financial reporting. Using a sample of firms disclosing internal control weaknesses during November 2003–July 2005, I find that firms with low internal control quality are more likely to have lower credit ratings, speculative-grade rating, smaller size, lower profitability, lower cash flows from operating activities, net losses in the current and prior fiscal year, higher income variability and higher leverage than firms compared to firms with high-quality controls. Further, lower quality controls decrease the likelihood of a firm receiving an investment-grade debt rating; hence, resulting in higher cost of debt financing, lower income and lower overall attractiveness in capital markets for these firms. Finally, results also suggest that corporate governance strength is positively related to internal control quality. Study results should be useful to a wide range of academic and business readers, because it suggests the increasing importance of firm internal controls in financing decisions and cost of capital determination, of investment in proper internal controls and of exploring the various possibilities from instituting high-quality internal controls. Additionally, regulators are advised to take into consideration the potential effect of legislation on firm credit ratings and internal control quality.

How Non-Banks Increased the Supply of Bank Loans: Evidence from Institutional Term Loans

There is considerable evidence that the growth of non-bank institutional investors, primarily collateralized loan obligations, in the market for bank loans provided a significant increase in the supply of credit. Firms accessing the market for institutional term loans invested more in capital expenditures and working capital than otherwise similar firms. Since institutional investors have concentrated in lending to borrowers with speculative-grade debt ratings, the borrower's credit rating provides a natural instrument to show that borrowing from a non-bank has had a causal impact on firm investment. Institutional term loans have permitted borrowers to increase their leverage and strengthen their balance sheets by lengthening the maturity of their debt, further confirming that non-bank investors have increased the supply of credit. In response to the supply shock, there has been considerable growth in number of firms with speculative-grade ratings, driven primarily by firms acquiring new ratings to gain access to the institutional market. This result suggests that banks no longer have a comparative advantage in funding senior, secured debt that requires extensive monitoring of covenants. However, commercial banks remain the unique provider of revolving lines of credit, suggesting that banks comparative advantage rests in the provision of liquidity in the form of lines of credit.

The Relation between Corporate Governance and Credit Risk, Bond Yields and Firm Valuation

This study examines the empirical relations between the governance structure of public corporations in the United States and the rating and pricing of their debt securities. We study an unbalanced panel of 775 unique U.S. firms from 2001 through 2007 and identify several statistically significant relations between corporate governance factors and credit ratings, bond spreads and firm values. We find that credit ratings are negatively related to the presence of antitakeover measures for firms with speculative grade ratings and positively related to the presence of antitakeover measures for firms with investment grade ratings. Moreover, we find that spreads are positively related to the presence of antitakeover measures, and this relation is significantly stronger for firms with less than investment grade credit ratings. Our findings also suggest that more stable boards, defined as having attributes relating to board tenure, director liability indemnification and classified board structures are related to higher credit ratings and lower bond spreads. We conjecture that boards with greater stability may be better positioned to take into consideration the longer term interests of the firm as a whole, thus benefiting the firm's creditors.

An Analysis of Defaults of Long-term Rated Debts

Lately, the credit rating agencies have been the subject of significant criticism for failing to warn the investors of the defaults well in advance. Investors in long-term debt instruments are usually risk averse, buy-and-hold types; and hence, for them, the variability of investment-grade default rates is particularly important since they employ simple investment-grade rating cut-offs in the design of their investment eligibility plan. According to ICRA (Investment Information and Credit Rating Agency of India) and the other credit rating agencies, default means that the company has either already failed in the payment of interest and/or principal as per terms or is expected to fail. The debt rating at no time informs as to how much bond face value holders would recover in the event of a default. The present regulations pertaining to the credit rating agencies preclude the investors and issuers from suing agencies for awarding a particular rating. Hence, credit ratings are of value only as long as they are credible. This paper tests the reliability of ratings assigned by ICRA on the basis of the actual default rate experience on long-term debt across five sectors over a period of seven years, i.e., 1995–2002. The reason for including only long-term debt instruments for the purpose of analysis is that the assigned rating and its movement can be observed only over a long period. Since the credit rating agencies do not publish ratings that are not accepted by the issuers, this study is limited to only those issues that have been accepted and used by the issuers. The default statistics were examined sector-wise, period-wise, and company/institution-wise. Analyses of the background and business, operating performance, management and systems, financial performance, prospects, key issues, and the reasons cited for defaults were undertaken with respect to all the companies. Simple metrics like default rates by rating grades and rating prior to default were used to analyse whether low ratings (i.e., speculative-grade ratings) were assigned by ICRA to defaulting credits well in advance of default rate. Further, an attempt was made to identify whether companies in default had issued other debt instruments that were rated by other credit rating agencies. The findings highlight the following: The performance of the manufacturing sector vis-a-vis other sectors has been dismal. The period of high defaults (1997-1999) coincides with a high interest regime and poor economic conditions in India. ICRA's performance in terms of proper surveillance and provision of timely and complete information about the companies rated by them has not been up to the mark. The findings certainly draw attention towards the fact that excessive reliance on credit rating needs to be reduced. Since the governance of the credit rating agencies is questionable, adequate steps have to be taken to make them more accountable.