Rating Agency Beliefs and Credit Market Distortions

Abstract

The beliefs of credit rating agencies (CRAs) induce mispricing in bond markets which in turn affect firms’ financial and investment decisions. We measure CRA beliefs as the difference in forecasts of future aggregate credit spreads between CRAs and a consensus of other financial institutions. We show that when CRAs are relatively more optimistic, they issue higher credit ratings even though their forecasts do not contain additional information regarding future aggregate yields. Moreover, this optimism leads to lower initial yields and subsequent negative returns for newly issued bonds. In response to this mispricing, firms increase their debt levels, leverage and investment, where the effects are most pronounced among rated firms. Finally, when CRAs are more optimistic, firms are more likely to be rated. Our results are consistent with investors being overly reliant on the beliefs of rating agencies, causing mispricing in credit markets, which firms then take advantage of. Overall, our analysis shows how CRA beliefs drive aggregate financing and investment behavior through mispricing in credit markets.

Presentation

Notre Dame

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