The Effect of Credit Ratings on Disclosure: Evidence from the Recalibration of Moody's Municipal Ratings

• Author: JACQUELYN R. GILLETTE,DELPHINE SAMUELS,FRANK S. ZHOU
• Published date: 01 June 2020
• DOI: http://doi.org/10.1111/1475-679X.12307
• Date: 01 June 2020

DOI: 10.1111/1475-679X.12307

Journal of Accounting Research

Vol. 58 No. 3 June 2020

Printed in U.S.A.

The Effect of Credit Ratings on

Disclosure: Evidence from the

Recalibration of Moody’s Municipal

Ratings

JACQUELYN R. GILLETTE ,∗DELPHINE SAMUELS,

∗

AND FRANK S. ZHOU

†

Received 30 March 2018; accepted 5 March 2020

ABSTRACT

This paper examines how credit rating levels affect municipal debt issuers’

disclosure decisions. Using exogenous upgrades in credit rating levels caused

by the recalibration of Moody’s municipal ratings scale in 2010, we find that

upgraded municipalities significantly reduce their disclosure of required con-

tinuing financial information, relative to unaffected municipalities. Consis-

tent with a reduction in debtholders’ demand for information driving these

results, the reduction in disclosure is greater when municipal bonds are

∗Sloan School of Management, MIT; †The Wharton School, University of Pennsylvania.

Accepted by Christian Leuz. We gratefully acknowledge helpful comments and sug-

gestions from John Core, Christine Cuny (discussant), Paul Fischer, Wayne Guay, Linda

Myers (discussant), James Naughton, Andrew Sutherland, Dan Taylor, Rodrigo Verdi,

Gregory Waymire (discussant), Joseph Weber, Aaron Yoon (discussant), two anonymous

reviewers, and workshop participants at the 2019 INSEAD Accounting Symposium, 2019

Hoosier Accounting Research Conference, Northwestern University, 2019 UC Davis con-

ference, 2018 Dartmouth Accounting Research Conference, 2018 Washington University

Nick Dopuch Conference, Georgetown University, 2018 Hawaii Accounting Research

Conference, MIT, University of Massachusetts Boston, and the Wharton School. We

thank Manuel Adelino for sharing data on Moody’s recalibration. Frank Zhou thanks

the University of Chicago Booth School of Business IGM and Wharton Dean’s Re-

search Fund for financial support. An online appendix to this paper can be downloaded

at http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

693

CUniversity of Chicago on behalf of the Accounting Research Center, 2020

694 J.R.GILLETTE,D.SAMUELS,AND F.S.ZHOU

held by investors who relied more on disclosure ex ante. However, we also

find that the reduction in disclosure does not manifest when issuers are

monitored by underwriters with greater issuer-specific expertise and when

issuers are subject to direct regulatory enforcement through the receipt of

federal funding. Overall, our results suggest that higher credit rating levels

lower investor demand for disclosure in the municipal market, and highlight

the role of underwriters and direct regulatory enforcement in maintaining

disclosure levels when investor demand is low.

JEL codes: G24; G28; H74; M40; M41

Keywords: municipal bonds; municipal disclosure; credit ratings; Moody’s

recalibration; underwriters; Single Audit Act

1. Introduction

The municipal bond market is critical in funding the nation’s infrastruc-

ture. As of 2018, over 44,000 state and local governments owed $3.7 trillion

in municipal bonds outstanding to fund their daily operations and a wide

variety of public projects, such as roads, schools, water systems, and hospi-

tals (SIFMA [2018]). However, unlike the corporate environment, where

an abundance of information is available through issuers’ disclosures and

various information intermediaries, this market is notoriously opaque. Al-

though municipal bond issuers are required to file annual financial infor-

mation, they often fail to provide investors with even basic financial state-

ments after the initial offering, or provide these “continuing disclosures”

with a significant delay (SEC [2016]).1Regulators have advocated for dis-

closure reform since the early 1900s (Zimmerman [1977]), and prior liter-

ature suggests that this lack of transparency benefits broker–dealers at the

expense of household investors (e.g., Cuny [2018]) and furthers dealers’

monopoly power (Green, Hollifield, and Sch¨

urhoff [2006]).

The widespread lack of compliance with the requirement to file annual

financial information calls for a better understanding of the determinants

of municipal disclosure. In this paper, we examine the role of credit rating

agencies in municipalities’ continuing disclosure decisions. A distinct

feature of the municipal market is the large presence of retail investors,

who rely on credit ratings for their investment decisions (SEC [2012]).2

Given this reliance, credit ratings are likely to affect these investors’

demand for municipal disclosures. In particular, theory predicts that, as

credit risk decreases, debtholders’ payoffs become less sensitive to new

1For example, nearly 40% of municipalities failed to file any continuing disclosures in 2009

(Schmitt [2011]).

2Retail investors accounted for 67% of municipal bond holdings at the end of 2016 (44%

direct holdings and 23% indirect holdings through mutual funds, money market funds, and

Exchage-Traded Funds, according to the U.S. Flow of Funds Accounts quarterly data). The

SEC’s recent report on the municipal securities market states: “Although issuers disclose fi-

nancial information in various disclosure documents available to investors, market participants

noted that many investors nonetheless rely on municipal credit ratings” (SEC [2012, p. 52]).

THE EFFECT OF CREDIT RATINGS ON DISCLOSURE 695

information about issuers’ economic fundamentals (e.g., Easton,

Monahan, and Vasvari [2009], Merton [1974]). Consequently, an in-

crease in credit rating levels that lowers debtholders’ perception of credit

risk should reduce their demand for information. To the extent that

municipal issuers exercise discretion over providing continuing disclosure,

they should respond by reducing the supply of disclosure.

Although the theory is intuitive, municipal disclosure does not neces-

sarily vary with credit rating levels. In this market, retail investors typically

have limited information-processing abilities and hold bonds to maturity

(SEC [2012]). These investors may thus have little demand for disclosure

after the initial bond offering, implying that an increase in credit rating

levels could have an insignificant effect on continuing disclosure. Further,

municipalities may also respond to potential disclosure demands of their

other constituents, such as citizens, which do not necessarily depend on

credit rating levels. Finally, a number of gatekeepers jointly enforce mu-

nicipalities’ disclosure requirements and can act as countervailing forces

against a reduction in continuing disclosure. Thus, the effect of credit rat-

ings on municipal disclosure is an empirical question.

To identify the effect of municipal credit ratings on disclosure, we ex-

ploit the recalibration of Moody’s municipal rating scale. In April 2010,

Moody’s recalibrated its ratings to the global rating scale (GRS), which up-

graded the rating levels of over 18,000 municipal entities. Importantly, the

recalibration only represented a change in scale and did not result from

changes in issuers’ underlying credit risk or other economic fundamen-

tals that could be related to their disclosure incentives.3Although issuers’

fundamental credit risk remained unchanged, recent evidence shows that

investors nevertheless believed that the increased rating levels represented

a drop in credit risk (Adelino, Cunha, and Ferreira [2017], Cornaggia, Cor-

naggia, and Israelsen [2018], Beatty, Gillette, Petacchi, and Weber [2019]).

Based on our prediction, investors’ perception of a reduction in credit risk

reduces their demand for disclosure, and municipalities thus disclose less.

Using this shock to credit rating levels, we examine whether rating up-

grades alter municipalities’ continuing disclosure of financial information,

defined as the likelihood and frequency of disclosing any financial infor-

mation after the initial offering.4We use a difference-in-differences design

to compare the continuing disclosures of municipalities that experienced

3Moody’s [2010] makes this point explicit in discussing the recalibration: “This recalibra-

tion does not reflect an improvement in credit quality or a change in our credit opinion for

rated municipal debt issuers. Instead, the recalibration will align municipal ratings with their

global scale equivalent” (p. 1).

4Debt issuers are expected to file continuing financial disclosures on the Municipal Secu-

rities Rulemaking Board’s (MSRB’s) online dissemination platform after a primary offering

(i.e., after a primary offering, issuers are expected to file annual financial disclosures to keep

investors updated about their credit quality). We measure municipal disclosure broadly, us-

ing measures of both the existence and frequency of all continuing municipal financial fil-

ings (including audited financial statements, unaudited annual financial and operating data,