MANAGING FOR RATINGS: REAL EFFECTS OF A CORPORATE RATINGS CRITERIA CHANGE

• Author: Janet Payne,Emmanuel Alanis,Joerg Picard
• Published date: 01 December 2020
• DOI: http://doi.org/10.1111/jfir.12226
• Date: 01 December 2020

The Journal of Financial Research Vol. XLIII, No. 4 Pages 821–845 Winter 2020

DOI: 10.1111/jfir.12226

MANAGING FOR RATINGS: REAL EFFECTS OF A CORPORATE RATINGS

CRITERIA CHANGE

Emmanuel Alanis

Texas State University

Janet Payne

Texas State University

Joerg Picard

Grand Valley State University

Abstract

We exploit a criteria change by Standard & Poor’s (S&P) to examine the real effects

of a credit ratings change. Using a recalibration by S&P, unrelated to firms’

fundamentals, as a quasi‐natural experiment we analyze the impact of a ratings

upgrade on the issuance activity, investment, cash holdings, and payout policy of

companies. Our findings suggest upgraded firms subsequently issue more debt

relative to equity, enjoy lower debt yields, and increase their investment rate and

share repurchases. We find limited evidence that upgraded firms decrease their cash

holdings. Our results support the view that credit ratings have a real effect on

corporations.

JEL Classification: G30, G31

I. Introduction

Substantial empirical evidence suggests that managers take the potential for credit

rating changes into account when making corporate decisions (see Kisgen 2006, 2009;

Hung, Banerjee, and Meng 2017). Evidence also suggests that investors view ratings

changes as a valuable source of new information (Pinches and Singleton 1978;

Holthausen and Leftwich 1986; Dichev and Piotroski 2001).

These actions make sense when rating changes are made in response to

changes in managerial decisions or the firm’s fortunes. However, what happens when

firm ratings are changed because of an exogenous event that is out of management’s

control, such as when a credit rating agency (CRA) changes its ratings criteria? When

rating changes are not due to managerial actions or new economic conditions, do they

still provide information to market participants? Do managers react to the new rating?

We thank an anonymous reviewer, Vijay Gondhalekar, William Grieser, Charles Hadlock, Murali

Jagannathan (editor), Shane Johnson, Omesh Kini, Costanza Meneghetti, Margot Quijano, Chenguang Shang,

Lingling Wang, Ha‐Chin Yi, and seminar participants at the Southwestern Finance Association annual meeting

and at Texas State University.

821

© 2020 The Southern Finance Association and the Southwestern Finance Association

In November 2013, Standard & Poor’s (S&P) updated—or recalibrated—the

criteria it uses to assign bond ratings to corporate issues. This update in criteria resulted

in a change of ratings for 50 U.S. companies: 44 upgrades and 6 downgrades. These

ratings changes are particularly interesting because they resulted from a change in the

“rules of the game”over which companies had no influence, rather than from corporate

managers’actions or the firm facing a new economic environment.

Isolating the true impact of credit ratings on corporate actions is difficult

because of endogeneity concerns. CRAs evaluate corporate actions at the same time

managers take those actions with an eye on their credit rating, and the economic

environment of the company can change rapidly. This feedback makes it difficult to

test the real impact of a credit rating change. S&P’s technical change criteria create a

quasi‐natural experiment that sidesteps this endogenous feedback. Furthermore, S&P

explicitly announced which firms were affected by the criteria change and this provides

us with a clean sample of firms affected by the exogenously determined rating change.

These changes are fundamentally different from periodic changes due to managerial

actions or changes in economic outlook.

We create a matched sample of 31 firms that experienced a ratings upgrade

because of this technical criteria change, or recalibration, and conduct a difference‐in‐

difference estimation to investigate its impact on firms’corporate policies. Our main

findings suggest that firms that experienced an upgrade in their credit rating increased

their net issuance of debt relative to equity and enjoyed lower cost of debt, consistent

with companies taking advantage of their improved market access. Furthermore,

upgraded firms increased their investment rate relative to their matched control sample

and increased their net share repurchases following the unexpected upgrade. We also

find weak evidence that these companies decreased their cash holdings.

We interpret these findings as consistent with companies managing their

ratings and having, at the margin, lower precautionary savings motives after the rating

upgrade. All else equal, a higher credit rating helps these firms raise external funds in

the future, if needed. Upgraded firms seem to use part of their previously built cash

reserves to fund investments and pay back shareholders. These results are consistent

with Acharya, Davydenko, and Strebulaev (2012) who find that firms with lower credit

ratings—which are more likely to be financially constrained in the future—hoard more

cash as a buffer against future uncertainty. In support of this interpretation we find that,

relative to their matched sample, upgraded firms issue public bonds at a lower yield

after their rating was increased, suggesting improved access to debt capital markets.

An equity event study around the rating change date does not reveal

statistically significant abnormal stock returns for the upgraded firms. This finding is

consistent with the literature that does not find a stock reaction to ratings upgrades

(Hand, Holthausen, and Leftwich 1992; Dichev and Piotroski 2001; Purda 2007) and

supports the view that equity investors realized the nature of the rating change as a

technical outcome and treated it as a nonvalue event. However, the abnormal returns

are positive and economically large, which could also be interpreted as equity investors

reacting positively to the news but valuing it as a relatively modest event. Also, the

number of observations in our sample (31 firms with rating upgrades) is low and we

822 The Journal of Financial Research