Three Essays on Corporate Credit Ratings

Basu, Riddha Sattam

doi:https://doi.org/10.21985/n2-t4x8-be33

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Three Essays on Corporate Credit Ratings

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This dissertation explores our understanding of corporate credit ratings. In the first chapter I examine the issue of split ratings. S&P and Moody’s often differ in their initial ratings at bond issuance, producing what is referred to as a split rating. The consensus view in the literature and in practice is that split ratings arise due to opinion differences across rating agencies about the drivers of credit quality. As a result, split ratings are believed to be useful for understanding a firm’s underlying credit quality. I question this consensus view by examining whether catering, which occurs when rated firms are treated favorably by rating agencies, also contributes to split ratings. Using a proprietary dataset that contains the actual firm-level adjustments made by S&P credit analysts, I find that more favorable financial statement adjustments by S&P are associated with a higher frequency of split ratings. I further show that the frequency of split ratings increases more for firms that reach the investment grade cutoff (BBB-) due to these favorable adjustments. I also find that these firms are more likely to receive a downgrade within the next year by S&P, even though no such downgrades are observed for Moody’s, suggesting that the initial rating was inflated. These results cannot be explained by opinion differences. Rather, these findings suggest that bias in the credit rating process generates split ratings. In the second chapter my co-author Jim Naughton and I examine whether the recognition versus disclosure of identical accounting information affects the credit rating process and ultimately corporate credit ratings. The primary input into corporate credit ratings is adjusted financial statements, which the rating agencies create by modifying reported financial statements to reflect credit-relevant items not recognized under U.S. GAAP. The rating agencies have claimed that this process means that accounting changes that move previously disclosed information onto firms’ financial statements have virtually no effect on firms’ adjusted financial statements or their credit ratings. We show that this claim is incorrect using the implementation of Financial Accounting Standards Board Statement No. 158 (“SFAS158”). This standard did not prescribe any new financial information. Rather, it simply required the balance sheet recognition of a previously disclosed item. We find that firms recognizing an additional pension liability due to SFAS158 had lower leverage on the rating agency adjusted financial statements and received higher corporate credit ratings. This counterintuitive result occurs because the rating agency adjustments made pre-SFAS158 were punitive relative to the combination of the SFAS158 changes and the rating agency adjustments made post-SFAS158. The difference in rating agency adjustments pre- and post-SFAS158 was primarily due to rating agency adjustments in the pre-SFAS158 period that did not account for minimum liability adjustments, an aspect of pension accounting eliminated by SFAS158. Overall, our results indicate that SFAS158 generated real changes in rating agency adjustments, and that these changes had real consequences for firms’ credit ratings. In the third chapter my co-authors Jim Naughton and Clare Wang and I look at the effect of corporate credit rating “labels” on firm’s disclosure policy. We provide evidence suggesting that corporate credit rating changes have an effect on firms’ voluntary disclosure behavior that is independent of the information they convey about firm fundamentals. Our analyses exploit two separate quasi-experimental settings that generate either exogenous credit rating downgrades or credit rating upgrades that allow us to isolate the effect of the credit rating label from changes in firms’ credit quality. We find evidence of a negative relation between the direction of the credit rating change and the provision of voluntary disclosure in both settings—firms respond to exogenous downgrades by increasing voluntary disclosure and to exogenous upgrades by decreasing voluntary disclosure. Overall, our analyses indicate that credit rating agencies as information intermediaries influence firms’ provision of voluntary disclosure.

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