Rating Agency Beliefs and Credit Market Distortions

Abstract

Credit rating agencies (CRAs) make regular forecasts of the future credit market conditions and explicitly incorporate these forecasts in their credit rating processes. We show that CRAs beliefs induce mispricing in corporate bond markets, which in turn affect firms’ financial and investment decisions. We propose a measure of CRA subjective beliefs as the difference in forecasts of future aggregate credit spreads between CRAs and a consensus from many other financial institutions. When CRAs are relatively more optimistic, they issue higher credit ratings despite their lack of additional information regarding future credit market conditions. CRA optimism leads to lower initial yields and subsequent negative returns for newly issued bonds. In response to this mispricing, firms increase their debts, leverage, and investments—where the effects are most pronounced among rated firms—and unrated firms are more likely to be rated.

Presentation

Notre Dame, McGill, CICF 2022, AsianFA 2022

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