THE INFORMATIONAL ROLE OF BANK LOAN RATINGS

• Author: Donald J. Mullineaux,Ha‐Chin Yi
• Published date: 01 December 2006
• Date: 01 December 2006
• DOI: http://doi.org/10.1111/j.1475-6803.2006.00190.x

The Journal of Financial Research •Vol. XXIX, No. 4 •Pages481–501 •Winter 2006

THE INFORMATIONAL ROLE OF BANK LOAN RATINGS

Ha-Chin Yi

TexasState University

Donald J. Mullineaux

University of Kentucky

Abstract

Weanalyze the relatively new phenomenon of credit ratings on syndicated loans,

asking first whether they convey information to the capital markets. Our event

studies show that initial loan ratings and upgrades are not informative, but down-

grades are. The market anticipates downgrades to some extent, however. Wealso

examine whether public information reflecting borrower default characteristics

explains cross-sectional variation in loan ratings and find that ratings are only

partially predictable. Our evidence suggests that loan and bond ratings are not

determined by the same model. Finally,we estimate a credit spread model incor-

porating bank loan ratings and other factors reflecting default risk, information

asymmetry, and agency problems. We find that ratings are related to loan rates,

giventhe ef fect of other influences on yields, suggesting that ratings provide infor-

mation not reflected in financial information. Ratings may capture idiosyncratic

information about recovery rates, as each of the agencies claims, or information

about default prospects not available to the market.

JEL Classification: D82, G10, G21

I. Introduction

Investors have long relied on corporate and municipal bond ratings to form judg-

ments about potential defaults, whereas academics have addressed the rationale

for rating agencies and the relevance of ratings in the capital markets. For exam-

ple, Millon and Thakor (1985) provide an analytical basis for information-sharing

services, and Hand, Holthausen, and Leftwich (1992), among others, show that

credit ratings influence bond yields and that rating downgrades adversely affect an

issuer’s debt and equity prices.

In the mid-1990s, the major rating agencies (Moody’s, Standard & Poor’s,

and Fitch) began to rate syndicated bank loans. There has been no academic research

The authors are grateful to Mukhtar Ali, Roger Arner, Richard Cantor, Mark Flannery (the referee),

Brad Jordan, Joe Peek, and Breck Robinson for helpful comments and suggestions.

481

482 The Jo urnal o f Financ ial Research

on this topic, although the rating agencies themselves havepublished some analyses.

In this article, we address whether loan ratings: (1) inform capital markets, (2) are

readily predictable,(3) are deter mined differently from bond ratings, and (4) contain

idiosyncratic information.

We examine the first issue in an event-study framework and find results

similar to those in the bond literature. Equity prices of borrowers decline when

their loans are downgraded, but excess returns are not affected by either initial

rating announcements or loan upgrades. We show that loan ratings are predictable

from variables capturing borrower default characteristics and that loan and bond

ratings are not determined by identical models. We examine the final issue by

estimating a model of loan credit spreads and find that loan ratings are consistently

and significantly related to loan rates, even in the presence of financial factors

affecting default risk. The results are consistent with the agencies’ claims that loan

ratings contain their private information, presumably capturing either the prospect

for default or for recovery if default occurs.

II. Rationale for Loan Ratings

Several factors prompted the agencies to enter the loan rating business. First, the

syndicated loan market was growing rapidly in the 1990s, with annual volume

topping $1 trillion by the end of the decade. Dennis and Mullineaux (2000) examine

the factors that drive loan syndications. Second, institutional investors recognized

bank loans as a distinct asset class and entered the loan market as buyers in the 1990s,

while investmentbanks entered as originators and sellers. Pension and mutual funds,

investmentbanks, and insurance companies were unfamiliar with the characteristics

and risks of syndicated loans relative to bonds, and the rating agencies concluded

they could fill this information gap. Moody’s (1995) emphasizes that loan ratings

enhance liquidity and efficiency in the secondary market for bank loans. Altman,

Gande, and Saunders (2004) find that bank loan markets are relativelymore ef ficient

than bond markets in the face of information-intensive events such as default or

bankruptcy in that secondary-market loan prices fall more than bonds before default

or bankruptcy announcements and relatively less in the short periods surrounding

these announcements. Their results are consistent with the monitoring advantages

commonly attributed to banks in the literature and suggest that loan ratings might

make smaller contributions to market efficiency than bond ratings.

The loan and bond rating processes have some similarities but also some

potentially important differences. In particular, the agencies conduct a financial

analysis of the borrowing firm, including a face-to-face due diligence meeting with

management. They conduct historical and peer-group-based financial ratio analysis,

evaluate operating and financial policies, project cash flows and profitability, ex-

amine organizational and governancestr uctures, and reviewthe borrower’sstrategic