Split Ratings and Differences in Corporate Credit Rating Policy between Moody's and Standard & Poor's

• Date: 01 November 2014
• DOI: http://doi.org/10.1111/fire.12054
• Author: Waseem Larik,Michael Bowe
• Published date: 01 November 2014

The Financial Review 49 (2014) 713–734

Split Ratings and Differences in Corporate

Credit Rating Policy between Moody’s and

Standard & Poor’s

Michael Bowe∗

Manchester Business School, University of Manchester

Waseem Larik

Bank of Montreal

Abstract

This paper investigates split credit ratings awarded by Moody’s and Standard & Poor’s

(S&P) to U.S. corporations. Bivariate probit model estimates, analyzing 5,238 firm-year ob-

servations from dual-rated S&P 500/400/600 index-constituent corporations, indicate firm-

specific financial and governance characteristics predict split ratings. Large,profitable compa-

nies with enhanced interest coverage, a greater percentage of independent directors, and more

institutional investment are less likely to receivesplits. Moody’s appears more conservative in

its evaluations, assigning lower ratings to smaller, less profitablecompanies with low interest

coverage. Moody’s also associates external, independent constraints on managerial autonomy

with a higher corporate credit standing relative to S&P.

∗Corresponding author: Manchester Business School, University of Manchester, Booth Street West,

Manchester M15 6PB, UK; Phone: +44 161 306 3407; Fax: +44 161 275 4023; E-mail:

mike.bowe@mbs.ac.uk.

We gratefully acknowledge the comments of Ralf Becker, Pedro Gomes, Owain ap Gwilym, Stuart

Hyde, Christopher Mann, Khelifa Mazouz, Philip Rother, Brahim Saadouni, Antonios Siganos, Kostas

Stathopoulos, Alex Taylor, Randall Valentine, the editor, Bonnie Van Ness, and anonymous referees of

this journal, as well as participants at the 2011 US Academy of Business conference and 2012 British

Accounting and Finance Association conference on earlier versions of this paper.

C2014 The Eastern Finance Association 713

714 M. Bowe and W. Larik/The Financial Review49 (2014) 713–734

Keywords: corporate ratings, split credit ratings, governance, ratings policy

JEL Classifications: G24, G28, G38

1. Introduction

Moody’s and Standard & Poor’s(S&P) dominate the global credit ratings indus-

try.1Indeed, financial services regulations2endorse their privileged position, sanc-

tioning the two major credit rating agencies (CRAs) preferential access to proprietary

corporate information in relation to other investment professionals. Notwithstanding

such advantages, Moody’s and S&P commonly disagree in their assessment of credit

quality and often assign split credit ratings to a corporation or a specific security

issue. Evidence suggests that approximately 20% of rated U.S. corporate bond issues

receive category-level split ratings, while around 50% of subratings or notch-level

ratings are splits3(Ederington, 1986; Jewell and Livingston, 1998; Livingston, Wei

and Zhou, 2010).

The economic and financial consequences arising from the award of a split

rating to a corporation are potentially significant. Financial market regulations can

restrict investors from investing in firms or securities that do not possess investment

grade ratings from the two major CRAs. Asset pricing studies reveal the award of

split ratings affects yields on bond issues trading in the secondary market, albeit

there is no clear consensus as to the direction of influence. Liu and Moore (1987)

allege that bond yields on split-rated issues reflect the lower of two ratings, while

Hsueh and Kidwell (1988) and Reiter and Ziebert (1991) maintain that they are

determined by the higher rating. Livingston, Wei and Zhou (2010) conclude split-

rated bonds average a 7-basis-point yield premium over congruent-rated bonds of

comparable credit risk. Jewell and Livingston (1998) and Gilloon (2010) propose

that the influence of split ratings on yields depends on the investment time horizon.

Surveys of U.S. and European fund managers corroborate these contrasting findings.

Cantor, Thomas and ap Gwilym (2007) find that 16% of the responding U.S. fund

managers make portfolio decisions using the higher of the two ratings, while 22% use

1Over our sample period, the combined market share of Moody’s and S&P is around 80%. “Rating the

rating agencies,” The Economist, May 31, 2007.

2Regulation Fair Disclosure (FD), implemented on October 23, 2000, prohibits U.S. public companies

from making selective, nonpublic disclosures to favored investmentprofessionals. This regulation has a

specific exclusion enabling rating agencies to access such nonpublic information.

3On the basis of S&P/Moody’s rating descriptors, a category-level split differentiates AA/Aa from both

A/A and AAA/Aaa, but not from AA+/Aa1 and AA−/Aa3, while AA/Aa2 is distinct from both the

latter ratings in a notch-level split. S&P and Moody’s introduced notch-level ratings in 1974 and 1982,

respectively.As indicated, notch rating categories are given plus and minus symbols by S&P,and numerical

categories 1, 2, and 3 in the case of Moody’s.