INFORMATION OPACITY AND FITCH BOND RATINGS

• Author: Lei Zhou,Miles Livingston
• Published date: 01 December 2016
• Date: 01 December 2016
• DOI: http://doi.org/10.1111/jfir.12110

INFORMATION OPACITY AND FITCH BOND RATINGS

Miles Livingston

University of Florida

Lei Zhou

Northern Illinois University

Abstract

We examine the marginal impact of Fitch ratings on the at-issuance yields of industrial

and utility bonds rated by Moody’s and Standard & Poor’s. We find that Fitch ratings

reduce the yield premiums on information-opaque bonds by about 30%, or 15 basis

points. The finding is robust even when a Fitch rating exactly equals the two major

ratings or their average. The findings suggest that Fitch ratings are not redundant but

bring additional information to investors. Increased competition in the rating industry

enhances the information efficiency of the bond market, and the existence of smaller

rating agencies is economically justified.

JEL Classification: G12, G24

I. Introduction

Until recently, the U.S. credit rating industry was dominated by two major rating

agencies, Moody’s and Standard & Poor’s (S&P). To increase competition, the U.S.

Securities and Exchange Commission has granted more rating agencies the status of

Nationally Recognized Statistical Rating Organization in recent years. In addition,

through industry consolidation and acquisition, Fitch has established itself as an

alternative and viable competitor to the two major rating agencies. In 1997, Fitch merged

with the London-based IBCA, a rating agency specializing in the financial industry. In

2000, Fitch acquired Duff and Phelps Credit Rating Co. and Thomson Financial

BankWatch. Through both organic and inorganic growth, Fitch’s market share increased

from about 10% in the mid-1990s to almost 50% today. In the meantime, Fitch ratings are

increasingly accepted by investors. For example, the Lehman (now Barclay Capital)

Corporate Bond Indices started to incorporate Fitch rating (in addition to those of

Moody’s and S&P) into their classification of investment-grade bonds in 2005.

Acquiring a third rating from Fitch involves additional rating fees for issuing

firms. Fitch has two rating fee arrangements. First, it charges a per issue rating fee, which

ranges from $1,000 to $750,000 per issue. Second, an issuing firm can request ratings on

We would like to thank seminar participants at the University of Florida, Northern Illinois University,

University of Arkansas, University of Melbourne, University of New South Wales, Victoria University

Wellington, University of Sydney, University of Technology Sydney, Massey University, and the Associate Editor

Andrea Heuson for helpful suggestions and comments.

The copyright line in this article was changed on 27 January 2017 after online publication.

The Journal of Financial Research Vol. XXXIX, No. 4 Pages 329–357 Winter 2016

329

© 2016 The Authors. The Journal of Financial Research published by Wiley Periodicals, Inc. on behalf of The Southern Finance Association and

the Southwestern Finance Association

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction in

any medium, provided the original work is properly cited.

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

all or a number of its bond issues for an annual fee, which varies from $100,000 to

$1,500,000 (Fitch 2016). The extra fees raise the question of whether issuing firms are

well served by an additional rating from Fitch.

Our study investigates the value of Fitch bond rating by examining its impact on

yield premiums of information-opaque bond issues. The value of an additional bond

rating lies in its ability to reduce information asymmetry. Our primary hypothesis is that a

third rating from Fitch, if information rich, will have differential impacts on information-

opaque versus information-transparent bond issues: a more pronounced impact on the

yields of information-opaque bonds than on the yields of information-transparent bonds.

Using a sample of 6,655 U.S. domestic, newly issued industrial and utility bond

issues rated by both Moody’s and S&P from 2000 to 2014, we find that a Fitch rating

reduces the yield premium on information-opaque bond issues by about 30%, or 15 basis

points, but its effect on the yields of information-transparent bond issues is relatively

minor. These findings are evidence that Fitch ratings contain valuable information that is

appreciated and priced by investors in the industrial and utility bond markets and that

increased competition in the rating industry benefits issuing firms and bond investors.

1

The yield-reduction effect of a third rating is not due to potential selection bias. We use

the instrument variable approach, Heckman’s (1979) two-stage treatment model, and

propensity score matching to adjust for possible unobservable and observable selection

bias. The yield-reduction effect of Fitch ratings is stronger after each of the treatments for

possible self-selection bias.

A major reason why an extra rating provides additional information is that rating

agencies provide detailed rating reports to their service subscribers or for a one-time fee

in addition to the publicly available alpha-numerical ratings. Discussion with fund

managers indicates that professional bond investors consider the rating reports

informative and “extremely helpful”because they contain additional information not

available from the letter ratings.

To further test the information cont ent of a Fitch rating, we examine the

special case where all three rat ing agencies assign the same rat ing or the Fitch rating

matches the average of the Moody’s and S&P ratings. For these bonds, an additional

Fitch rating does not improve the average rating but does potentially contain in its

rating reports information not otherwise available t o investors. In these cases, a Fi tch

rating does reduce yield spr eads for information-opaq ue bonds, indicating that F itch

ratings contain informatio n beyond that contained in the rat ings of Moody’sand

S&P.

Traditionally, credit rating agencies play the role of information providers and

create economic value by their superior ability to analyze, aggregate, and transmit

information about issuers’default risk. Our empirical results suggest that a Fitch rating

does provide valuable services for opaque bond issues and its additional information

content is priced by market participants. Furthermore, our findings indicate that the yield-

reduction effect of a Fitch rating is not solely driven by its regulatory function but is

1

Our findings apply to the market for public offerings of industrial and utility bonds. The market for

mortgage-backed securities and other structured finance products is relatively new and the dynamics of the rating

process are different from those of traditional corporate bonds.

330 The Journal of Financial Research