The Real Costs of Corporate Credit Ratings

Abstract

Credit rating agencies emphasize the importance of specific financial ratio thresholds in their rating process. Firms on the favorable side of these thresholds are more likely to receive higher ratings than similar firms that are not. I show that firms near these salient thresholds respond to the incentive to improve their appearance on this dimension by distorting real investment activities during periods leading up to bond issuance. These firms are significantly more likely to reduce R&D and SG&A expenditures compared to observationally similar firms not near a threshold. Subsequently, they are more likely to experience declines in innovation output, profitability, and Tobin's Q. These distortions highlight an important cost of arms-length financing and an adverse consequence of transparency in credit rating criteria.

Partisan Professionals: Evidence from Credit Rating Analysts

“…Focusing on credit analysts provides an interesting setting, because their expertise and career concerns should reduce the effect of partisan perception (e.g., Gentzkow, Glaeser, and Goldin (2006); Hong and Kacperczyk (2010)). At the same time, any effect of partisan perception on credit rating actions is likely to have implications for firms' cost of financing (Fracassi, Petry, and Tate (2016)), as well as their financial policy and investment decisions (Chernenko and Sunderam (2011); Begley (2015); Almeida, Cunha, Ferreira, and Restrepo (2017)).…”

EBITDA vs. Cash Flows in Bankruptcy Prediction on the Polish Capital Market

“…The other studies found that firms near thresholds of EBITDA-based ratios are more likely to reduce R&D and SG&A expenditures (boosting EBITDA) prior to bond issuance (Begley, 2013). Also, firms with loan contracts that contain covenants based on EBITDA are more likely to misclassify core expenses as special items, in order to increase EBITDA (Fan et al, 2016).…”

How Much is Too Much? Debt Capacity and Financial Flexibility

“…Firms have lower thresholds for the level of their rating (Kisgen (2009)) and put more effort into preventing downgrades than into achieving upgrades by actively reducing leverage when their current credit rating level is threatened (Begley (2013)). Moreover, stock price reactions after downgrades announcements are more pronounced than after upgrades and a constant level of a credit rating conveys a stable financial situation and a low uncertainty about the level of a firm's risk (Ederington and Goh (1998)).…”

“…We calculate the debt capacity as the critical debt ratio that triggers a downgrade in the creditworthiness of a firm. This debt ratio is of special relevance as firms have thresholds for their rating (Kisgen (2009)) and put high effort into preventing downgrades to convey a stable financial situation for future capital issues (Begley (2013)). Our definition of the debt capacity aims at identifying a critical debt ratio that firms try to avoid because exceeding this ratio leads to a downgrade which conveys negative information on the firm's financial 1 situation and results in negative shock to a firm's cost of capital.…”