Giuliano Iannotta

Do investors care about credit ratings? An analysis through the cycle

We investigate how the credit cycle affects the link between bond spreads and credit ratings. Using a simple model of the credit assessment process, we show that when the debt market is more opaque, the information content of ratings deteriorates, creating an incentive for investors to increase the amount spent on private information. We test this hypothesis empirically. Results show that when market opaqueness (proxied by the spread between Aaa- and Baa-rated bonds) increases, the explanatory power of ratings and other control variables deteriorates as investors increasingly price in non-public information.

Bank Regulation, Credit Ratings, and Systematic Risk

A model is presented that shows when (Basel Accord) capital standards and (FDIC) insurance premiums primarily reflect a bank’s physical expected default losses, a bank can increase its shareholder value by making loans and investing in bonds that have relatively high systematic risk. Such an incentive occurs because, holding expected default losses constant, credit spreads are higher for systematically risky debt as they reflect risk-neutral, rather than physical, expected default losses. If credit ratings are based on physical expected default losses, then credit rating-based regulation, such as the Basel “Standardized Approach,” will subsidize banks’ systematically risky investments.Using an international sample of almost 4,000 bonds, we test whether credit rating based- regulation can create the bank moral hazard predicted by our model. First, we estimate each bond issuer’s debt beta, a measure of the debt’s systematic risk, and find that it positively affects the bond’s credit spread, even after controlling for the bond’s credit rating. In contrast, the idiosyncratic risk of the issuer’s debt has no impact on its bond’s credit spread after accounting for the bond’s credit rating. Second, credit ratings only partially reflect systematic risk. If a bank chooses bonds within a given credit rating that have above median credit spreads, the systematic risk of its investments rises by an economically significant amount. Third, while Moody’s and S&P do not differ significantly in their assessments of systematic risk, the likelihood of a split rating (disagreement between raters over the same issue) decreases with the issuer’s beta.

Market Discipline in the Banking Industry: Evidence from Spread Dispersion

Do bond investors price hidden information? To address this question, we use a heteroscedastic regression model to empirically examine the factors affecting the spread dispersion unexplained by easy-to-observe issue characteristics (such as credit ratings, size, maturity, etc.). Two main results emerge from the empirical analysis. First, variables that accurately predict the spread of the typical bond lose their explanatory power for worse-rated, subordinated bonds with longer maturity and smaller face value. This result suggests that investors price hidden information. Secondly, unexplained spread dispersion increases for open-priced offers and decreases with the number of banks involved in the syndicate, indicating that primary market characteristics affect the investors’ ability to uncover hidden information.

Which Factors Affect Bond Underwriting Fees? The Role of Banking Relationships

The question of which factors are relevant in determining bond underwriting fees is empirically investigated by analysing 2,202 bond issues completed by European firms during the 1993 – 2003 period. Four major results emerge from the analysis. First, the introduction of the single currency in 1999 has generated an increase in competition among banks, and, as a result, a reduction in underwriting fees. Second, a strong relationship with the issuers main bank reduces the level of underwriting fees. Third, new issuers are charged with lower underwriter fees relative to firms that have completed issues without building any strong relationship with a bank. Fourth, higher reputation banks charge lower underwriting fees. The implications of these findings are also discussed.

Do Investors Care About Credit Ratings? An Analysis Through the Cycle

We investigate how the link between bond spreads and credit ratings is affected by the credit cycle. Using a simple model of the credit assessment process, we show that when the debt market is more opaque, the information content of ratings becomes poorer, creating an incentive for investors to increase the amount spent on private information. We test this hypothesis empirically. Results show that, when market opaqueness (proxied by the spread between Aaa and Baa-rated bonds) increases, the explanatory power of ratings and other control variables becomes poorer, as investors increasingly price in non-public information.

Equity Offerings: Syndicate Structure and Functions

In Chap. 3, when describing IPOs and other equity offerings, I referred to a single investment bank managing the issue. Although the whole process is usually managed by one or two banks, generally much more banks are involved to form a syndicate. In this chapter we will see how the syndicate is formed, what is its role and how the banks are compensated (Sect. 4.2). We will also take a deeper look to a peculiar function performed by investment banks once trading begins, i.e., after the IPO is actually concluded: stabilization of the stock price (Sect. 4.3).

Firm Opacity Lies in the Eye of the Beholder

Given the central role of firm opacity in most finance theories, empirical proxies that identify firm opacity correctly should allow for more powerful tests of these theories. The last decade has seen adoption of several different empirical proxies that aim to capture firm opacity. However, there is no study that has compared all of these measures. In this paper, we investigate how these different measures are related to each other. We classify the main empirical measures of firm opacity into three broad categories; those based on behavior of stock returns, those based on information produced by intermediaries such as stock analysts, and those based on market microstructure. Since opacity of depositary institutions has been focus of a number of recent studies, it provides a natural laboratory to test these different proxies. Our results show that while there is only a limited correlation among various opacity measures, most of them indicate that banks are less opaque compared to non-banks. Our failure to find consistent evidence on bank opacity suggests that the results are highly dependent on the opacity measure employed by the researcher. To measure the effectiveness of various opacity proxies, we use credit rating initiation as a significant shock to the firm information environment. We adopt a difference-in-difference approach, by comparing newly rated firms with “unchanged” firms, i.e. already rated or unrated firms. Our results suggest that the number of analysts and the price impact (as measured by the Amihud’s (2002) ratio) appear to be the most reliable proxies for firm opacity.

Risk Management in Mergers and Acquisitions

When negotiating a M&A transaction the Bidder should be concerned about the risk of overpayment, i.e., paying a purchase price too high relative to the Target value. This risk is more relevant when the Target has no track record or belongs to a relatively unknown (to the Bidder) industry: in such a situation the Bidder and the Target opinion about a fair closing price might be radically divergent, thus making the deal impossible. Alternatively, the Bidder might propose to pay part of the purchasing price in the future, contingent on the achievement of a given result by Target: this is an earnout agreement. In a stock deal also the Target’s shareholders might be worried about the performance of the combined firm, thus requiring some sort of price guarantee: usually this guarantee takes the form of contingent value rights. Even when the Bidder and the Target agree on the price, many things might happen between the signing and the actual closing of the deal. Think of a transaction where the form of payment is stock: suppose the two parties agree on a given exchange ratio and announce to the market the deal. Before closing they need the shareholders’ approval, the antitrust go-ahead, etc. These steps could require few months: what if at closing the relative price per share of the Target and the Bidder is dramatically different? Should the two firms re-negotiate? Or should they jump out of the deal? To avoid or limit these consequences collar agreement might be used: basically a collar limits the economic effects of a change in conditions between the announcement and the closing.

Hostile Takeovers and Takeover Regulation

This chapter provides an economic explanation of defense devices in hostile takeovers and takeover regulation. A Bidder willing to purchase a Target, might make directly an offer to the Target’s board of directors. It could be a bilateral negotiation or a sudden offer open just for a quick time. Investment bankers use some terms to indicate the different type of offers: for example a “bear hug” is an offer to the board not publicly announced or a “godfather offer” is an extremely high cash offer (so that the board is unable to refuse). In case the board refuses the offer, the Bidder can launch a tender offer to the shareholders. Since the offer is not supported by the Target’s board, it is a hostile bid. A successful hostile tender offer is likely to produce the changeover of the Target’s management. It is important to note that tender offers are not necessarily hostile: in other words, a tender offer might be the consequence of an agreement between the management of the Bidder and that of the Target. A tender offer is defined unsolicited until its nature is not defined (i.e., the attitude of the Bidder and Target are not known yet). The incentive, the process, and the outcome of any tender offer (hostile or friendly) is heavily influenced by the regulation in place.

Price Setting Mechanisms

This chapter analyzes the main price-setting mechanisms in security offerings, focusing on the most common practice, i.e., the open-price approach, better known as book-building. The price-setting mechanism is just a step in the whole offering process. However, the way the price is set is crucial, being the price the key variable of any offerings, both for debt and equity. The role of the investment bank is strictly related to the price setting mechanism. Indeed the process of a bond issue is not really different from that of an equity issue. Though, how difficult is pricing a bond issue compared to an equity issue? And within equity issues is it that difficult to price a seasoned equity offering (SEO), for which a publicly available market price already exists? In other words, the role of the investment bank tends to be even more crucial in IPOs, where the price is more “uncertain”. This is also why investment banking fees are much higher in IPOs than in any other security offering. The IPO process, the role of the investment banks involved in the transaction, the fee they get paid and many other aspects of an IPO depend on the kind of price-setting mechanism used.