Introduction

Credit Rating Agencies (CRAs) play a vital role on financial markets as screening agents. Many institutions, such as pension and mutual funds, make decisions regarding capital allocation based on credit ratings. It is no surprise that CRAs have a strong impact in the cost of debt and amounts issued for several institutions. In the aftermath of the late financial crisis, CRAs have been under a lot of scrutiny due to accusations of peddling ratings, due to conflicts of interest between the CRAs and the securities’ issuers, which in most instances pay directly the fees. There have been several accusations stating that

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CRAs were the main drivers to the late financial crisis, assigning artificial higher ratings, mainly to mortgage-backed securities.¹⁷

While much attention has been centered in mortgage-backed securities, only a few papers have analyzed CRAs standards for corporate bond credit ratings throughout time.

Contradictory to the slacking observed in mortgage-backed securities, observed prior to the 2007 financial crisis, the rating standards for corporate bonds have become more stringent over time. As mentioned by Nick Gartside: “In a way, double A has become the new triple A, when you have a lot less triple A debt out there”; suggesting a decline in credit quality. My findings contribute to the existing literature by showing that, even though CRAs have been more stringent with their rating standards, they tend to assign relative lower ratings for investment grade firms (firms with credit ratings higher or equal than BBB-) when compared to speculative grade firms (firms with credit ratings lower than BBB-). I then quantify the impact of this asymmetry in firm’s leverage decisions, net debt issuance and cash holdings. This asymmetry leads to different responses from investment grade and speculative grade firms. Most existing studies show that the increase in conservatism by CRAs is not justified by an increase in default rates. A possible explanation that this phenomenon is that CRAs are more lenient with newly rated firms, and most newly rated firms are speculative rated firms. I find this impact to be insufficient to fully explain this issue.

Credit ratings provide a ranking of the issuer credit quality. Credit ratings from Standards and Poor’s (S&P’s) do not include information regarding recovery rates or any issue’s specific provision. Credit ratings from S&P’s reflect only the issuer’s creditworthiness, reporting a default status if the issuer is not able to make a debt

17 There are several lawsuits related to inflated ratings before the late financial crisis. Please see the full article at https://dealbook.nytimes.com/2013/11/11/suit-charges-3-credit-rating-agencies-with-fraud-in-bear-stearns-case/?_r=0.

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promised payment. Credit ratings are supposed to establish the issuer’s long-term creditworthiness, not being influenced by temporary changes in business cycles (Amato and Furfine (2004)).

Over time, Moody’s reported a steady increase of downgrades in comparison to upgrades. Lucas and Lonski (1992) show that the long-term ratio of downgrades to upgrades deteriorated over time, peaking in 1990. S&P’s follows the same trend (Standards and Poor’s (2008a)), with downgrades consistently dominating the upgrades.

The evidence seems to suggest that credit quality have been deteriorating over time.

In this paper I extend the results from Baghai, Servaes and Tamayo (2014), which show that, holding firm’s characteristics constant, average credit ratings for U.S. firms have been declining over time due to the tightening of rating standards from CRAs. I examine U.S. corporate bond ratings, not mortgages backed or collateralized securities, over the period 1985 to 2015. I find that, holding firm characteristics constant, CRAs have been tightening their rating standards, decreasing average credit ratings between 2.7 and 3.2 notches by 2015 in comparison to 1985. This implies that a firm with a credit rating AA in 1985 would receive a credit rating of A in 2015. As in Blume, Lim and Mackinlay (1998) and Alp (2013) I find that for the period 1985-2002 average credit ratings for investment grade firms have been decreasing. As in Alp (2013), I find that CRAs start being more stringent with speculative grade firms after 2001. CRAs have been especially stringent with investment grade firms, on which defaults are less frequently but attract substantially more media attention, given the relative low default expectation. My results show that by 2015, holding firm’s characteristics constant, an investment grade firm would have a credit rating lower between 2 and 3 notches in comparison to 1985; while a speculative grade firm would have a rating lower by 1 notch

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or less in comparison to 1985. The loosening in ratings standards prior to 2002 for speculative grade firms is consistent with the 2002 Dot-com crash.

I also find that firms with a credit rating with “+” or “-” are relatively less affected by the tightening in rating standards. This result is consistent with Kisgen (2009) that shows that firms on a verge of an upgrade (downgrade) behavior differently and tend to improve their fundamentals in order to increase the likelihood of an upgrade (decrease the likelihood of a downgrade).

I quantify the impact from the stringent rating criteria in firm’s net debt issuance, leverage level and cash holdings for the period 2002-2015. The impact of the tightened rating criteria is computed by the difference between the actual credit rating and a credit rating predicted based on more lenient times (estimated using a sample from 1985 to 2001). My results are consistent with Baghai, Servaes and Tamayo (2014), and show that the increase tendency for CRAs to be more conservative reached its peak between 2010 and 2012.

Regarding firm’s net debt issuance, I find that a one-notch increase in the tightening of rating standards decreases net debt issuances by a total assets of 23.4%, given the sample average of net debt issuances to total assets of 2.56%. Investment grade firms react strongly than speculative grade firms, decreasing net debt issuances to total assets by 45.8% (given the sample average of 1.53%) instead of 17.5% (given the sample average of 3.43%) for speculative grade firms.

In respect to the total leverage, I find that the tightening in rating standards has a negative impact in firm’s leverage to total assets. A one-notch increase in the tightening of rating standards decreases leverage to total assets by 8.04%, given the sample average of market leverage to total assets of 34.8%. This result is present for different measures of firm’s leverage. Again, investment grade firms react more than speculative grade

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firms. Investment grade firms decrease market leverage to assets by 9.08% (given the sample average of 23.52%) while speculative grade firms decrease the same ratio by 3.9% (given the sample average of 45.82%).

For cash holdings, I find that a one-notch increase in the tightening of rating standards increases cash holdings to assets by 6.05% (given the sample average of cash holdings to assets of 8.26%). This impact is only statistically significant for investment grade firms and show a one-notch increase in the tightening of rating standards leads these firms to increase cash holdings by 10.39% (given the sample average of cash holdings to assets of 7.7%).

Overall, the empirical evidence that I provide is consistent with the view that time-series variation in credit ratings, through the tightening of credit ratings, is not fully warranted by firms, as shown in firm’s leverage levels, debt issuance and cash holdings.

Also, as Alp (2013) and Baghai, Servaes and Tamayo (2014) show the tightening in rating criteria is not fully warranted by an increase in default rates. However, this evidence is in contrast with most studies made on credit ratings from assets-backed securities which empirical evidence shows that have been inflated over time (see Pagano and Volpin (2010)). These findings combined suggest that, through time, CRAs have been disproportional tougher with investment grade than speculative grade firms, and progressively more relaxed for securities that are backed from some asset. Bolton, Freixas, and Shapiro (2012) show a theoretical framework on which conflicts of interest arise among issuers, investors and CRA’s that might distort the assignment of credit ratings.

My findings contribute for the increasing empirical evidence of time-series variations in credit ratings, while decomposing its effect between investment and speculative grade firms. Jorion, Shi, and Zhang (2008) show that credit ratings have been

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tightened over time. Jiang, Stanford, and Xie (2012) show that in 1974 S&P’s start to assign higher credit ratings due to the change from the investor-pay to the issuer-pay model. Alp (2013) added to the literature by showing that the tightening in credit ratings mainly manifests in investment grade firms and is not fully warranted by an increase in default rates. Baghai, Servaes and Tamayo (2014) add to the literature by exploring the impacts of the tightening in credit ratings in firm’s capital structure, growth, debt-spreads and cash holdings.

Changes in ratings standards are an important source of concern for financial managers. Graham and Harvey’s (2001) survey shows that the second most important factor to decide the firm’s capital structure is the debt’s credit rating. Also, Kisgen (2006) shows that firms target specific credit ratings when determining its capital structure. Tightening ratings standards in an asymmetric can lead to an increase the accessibility to debt markets of the relatively less affected firms. The lower quality firms, being relatively less affected by the stringent rating standards, can attain financing conditions that otherwise would not be possible.

Section 2 of this paper shows how the sample and main variables were constructed.

In section 3 I present the results from the rating regression models, which show the tightening in rating standards from investment and speculative grade firms throughout time. Sections 4 and 5 estimate the impacts of the tighten rating standards on firm’s debt issuance, leverage level and cash holdings, as well as several robustness tests to the ratings models.