Darren J. Kisgen

Do Firms Target Credit Ratings or Leverage Levels

Firms 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.

Did Government Regulations Lead to Inflated Credit Ratings

SEC regulations in 1975 gave select ratings agencies increased market power by increasing barriers to entry and reliance on ratings for regulations. We test whether these regulations led to lower ratings quality. We find that defaults and negative financial changes are more likely for firms given the same rating if the rating was assigned after the SEC action compared to before. Further, firms initially rated Baa post-regulations are 19% more likely to be negatively downgraded to speculative grade than firms rated Baa pre-regulations. These results indicate that the market power derived from the SEC led to ratings inflation. JEL Classification: G18, G24, G28, G32Securities and Exchange Commission (SEC) regulations in 1975 gave select rating agencies increased market power by increasing both barriers to entry and the reliance on ratings for regulations. We test whether these regulations led to ratings inflation. We find that defaults and negative financial changes are more likely for firms given the same rating if the rating was assigned after the SEC action. Furthermore, firms initially rated Baa in the post-regulation period are 19% more likely to be negatively downgraded to speculative grade than firms rated Baa in the pre-regulation period. These results indicate that the market power derived from the SEC led to ratings inflation. This paper was accepted by Amit Seru, finance.

The Real and Financial Effects of Credit Ratings: Evidence from Moody's Adjustments

Moody’s adjusts a firm’s reported leverage across several dimensions to determine credit ratings. I find that changes to this adjustment methodology affect firm capital structure and investment decisions. In particular, in 2006, Moody’s made several changes to its adjustment methodologies, which are arguably exogenous to changes in firm fundamentals. I first show these changes significantly affected adjustments for firms in this year. I then show that these changes to adjustments in 2006 affect capital structure and investment decisions in 2007, especially for those firms most affected by these methodology changes. These results show that rating agencies have the power to affect corporate decisions.

Fixed Income Fund Performance across Economic States

We evaluate the performance of fixed income mutual funds using stochastic discount factors motivated by continuous-time term structure models. Time-aggregation of these models for discrete returns generates new empirical “factors,” and these factors contribute significant explanatory power to the models. We provide a conditional performance evaluation for US fixed income mutual funds, conditioning on a variety of discrete ex-ante characterizations of the states of the economy. During 1985–1999 we find that fixed income funds return less on average than passive benchmarks that do not pay expenses, but not in all economic states. Fixed income funds typically do poorly when short-term interest rates or industrial capacity utilization rates are high, and offer higher returns when quality-related credit spreads are high. We find more heterogeneity across fund styles than across characteristics-based fund groups. Mortgage funds underperform a GNMA index in all economic states. These excess returns are reduced, and typically become insignificant, when we adjust for risk using the models.

Analyst Promotions within Credit Rating Agencies: Accuracy or Bias?

We examine whether credit rating agencies reward accurate or biased analysts. Using data collected from Moody’s corporate debt credit reports, we find that Moody’s is more likely to promote analysts who are accurate, but less likely to promote analysts who downgrade frequently. Combined, analysts who are accurate but not overly negative are approximately twice as likely to get promoted. Further, analysts whose rating changes are more informative to the market are more likely to get promoted, unless their ratings changes cause large negative market reactions. Moody’s balances a desire for accuracy with a desire to cater to its corporate clients.