The Real Effects of Credit Ratings: The Sovereign Ceiling Channel

• Author: IGOR CUNHA,HEITOR ALMEIDA,MIGUEL A. FERREIRA,FELIPE RESTREPO
• DOI: http://doi.org/10.1111/jofi.12434
• Date: 01 February 2017
• Published date: 01 February 2017

THE JOURNAL OF FINANCE •VOL. LXXII, NO. 1 •FEBRUARY 2017

The Real Effects of Credit Ratings: The Sovereign

Ceiling Channel

HEITOR ALMEIDA, IGOR CUNHA, MIGUEL A. FERREIRA,

and FELIPE RESTREPO∗

ABSTRACT

We show that sovereign debt impairments can have a significant effect on financial

markets and real economies through a credit ratings channel. Specifically, we find

that firms reduce their investment and reliance on credit markets due to a rising cost

of debt capital following a sovereign rating downgrade. We identify these effects by

exploiting exogenous variation in corporate ratings due to rating agencies’ sovereign

ceiling policies, which require that firms’ ratings remain at or below the sovereign

rating of their country of domicile.

SOVEREIGN DEBT IMPAIRMENTS have become a significant problem for developed

countries in the aftermath of the 2007 to 2009 global financial crisis and the

European sovereign debt crisis. France and the United States were downgraded

from an AAA credit rating for the first time in history, and other developed

countries including Greece, Ireland, Italy,the Netherlands, Portugal, and Spain

also experienced rating downgrades. How do sovereign debt impairments affect

financial markets and real economic activity?

We examine this question by exploring the consequences of sovereign rating

downgrades for firms’ cost of capital, investment, and financing decisions. Our

∗Heitor Almeida is at the University of Illinois at Urbana Champaign. Igor Cunha is at the

Nova School of Business and Economics. Miguel A. Ferreira is at the Nova School of Business and

Economics, CEPR, and ECGI. Felipe Restrepo is at the Ivey Business School at Western Univer-

sity. We thank Michael Roberts (the Editor), the Associate Editor, an anonymous referee, Viral

Acharya, Marco Bonomo, Murillo Campello, Sergey Chernenko, Paolo Colla, Jose Faias, Clifford

Holderness, VictoriaIvashina, Anastasia Kartasheva, Darren Kisgen, Spyridon Lagaras, Sebastien

Michenaud, Dean Paxson, Mitchell Petersen, Jun Qian, Henri Servaes, Kelly Shue, Rui Silva, Phil

Strahan, J´

erˆ

ome Taillard, David Thesmar,Yuhai Xuan, Mike Weisbach, participants at the Adam

Smith Workshop for Corporate Finance, Annual Conference on Corporate Finance at Washington

University, European Finance Association Annual Meeting, Financial Intermediation Research

Society Conference, NBER Summer Institute Workshop on Corporate Finance, Portuguese Fi-

nance Network, Lubrafin, and seminar participants at the Bank of Portugal, Chicago Booth School

of Business, Federal Reserve Bank of New York, Hong Kong University of Science and Technol-

ogy, INSPER, London School of Economics, Manchester Business School, National University of

Singapore, Rice University, University of Houston, University of North Carolina, and University

of Washington for helpful comments. Ferreira acknowledges financial support from the European

Research Council and Fundac¸˜

aoparaaCi

ˆ

encia e Tecnologia.We have read the Journal of Finance’s

disclosure policy and have no conflicts of interest to disclose.

DOI: 10.1111/jofi.12434

249

250 The Journal of Finance R

identification strategy exploits the variation in corporate ratings that is due

to rating agencies’ sovereign ceiling policies. These policies require that firms’

ratings remain at or below the sovereign rating of their country of domicile.

While rating agencies have been gradually moving away from a policy of never

rating a private borrower above the sovereign, corporate ratings that “pierce”

the sovereign ceiling are still not common (Standard & Poor’s Rating Services

(2012)).1

We show that the sovereign ceiling leads to an asymmetric change in cor-

porate ratings following a sovereign downgrade. Firms with a rating equal to

or above their sovereign prior to the downgrade (bound firms) are significantly

more likely to be downgraded after a sovereign downgrade than firms rated

below their sovereign (nonbound firms). One key advantage of our empirical

strategy is that nonbound firms have similar but lower credit quality than

bound firms. Thus, alternative explanations based on changes in fundamen-

tals and credit risk are not likely to explain the discontinuous change in ratings

around the sovereign ceiling. The asymmetric effect of sovereign downgrades

on firm ratings is thus likely to be due to the sovereign ceiling, and not to

changes in fundamentals.

We trace the financial and real consequences of this asymmetric effect of

sovereign downgrades on bound firms. Specifically, we find that bound firms

cut investment more than nonbound firms in the aftermath of a sovereign

downgrade. We also find some evidence that bound firms reduce net debt is-

suance and increase equity issuance more than nonbound firms following a

downgrade, although this evidence is not statistically as strong as the evidence

for investment. Finally, we find that sovereign downgrades also affect corpo-

rate bond markets, as the yields of bound firms increase more than the yields

of nonbound firms following a sovereign downgrade. The effect on the cost of

debt capital is statistically and economically significant.

Credit ratings are a major concern for corporate managers because of the

frictions associated with ratings (Kisgen 2006,2007)). First, ratings affect a

firm’s access to the bond and commercial paper markets, because rating levels

determine whether institutional investors such as banks or pension funds are

allowed to invest in a firm’s securities. Second, ratings affect the capital require-

ments applied to banks and insurance companies when they invest in specific

firms. Third, rating downgrades can trigger events such as bond covenant vio-

lations, increases in bond coupons or loan interest rates, and forced bond repur-

chases.2Finally, ratings can impact customer and employee relationships as

well as business operations, including a firm’s ability to enter into or maintain

1CFO Magazine summarizes the key implication of the sovereign ceiling as follows: “If a com-

pany is a better credit risk than its home country,it might still have trouble getting a credit rating

agency to recognize that fact” (see “Corporate, sovereign debt ratings closely linked: S&P,” CFO

Magazine, April 29, 2013).

2For example, performance-sensitive debt may incorporate explicit or implicit performance

pricing provisions that depend on credit ratings (Manso, Strulovici, and Tchistyi (2010)). Manso

(2013) shows that, in this setting, rating downgrades can significantly amplify adverse shocks to

firm fundamentals because of feedback effects between ratings and firm behavior.

The Real Effects of Credit Ratings 251

long-term contracts. Because of these effects, firms appear to react to rating

downgrades by reducing debt issuance and leverage (Kisgen (2009)).

We provide evidence on how rating downgrades matter in our context by

focusing on ratings-based regulation. Basel II bank capital requirements are

a nonlinear function of ratings. Because of this nonlinearity, some sovereign

downgrades are more likely to cause changes in capital requirements applied to

financial institutions. We find evidence that the financial and real consequences

of sovereign downgrades are stronger for downgrades that matter most for

capital requirements. While these results suggest that the regulation channel

plays a role, they need to be interpreted with caution due to the small sample

size and lack of statistical power.3

When financial markets operate normally, the consequences of sovereign

downgrades may not spill over into firm decisions and real economic activity.

For example, firms may be able to substitute equity for debt issuance. But

periods of sovereign downgrades are far from normal. Local financial markets

are likely to be in trouble, so it is difficult for firms to substitute equity for debt.

Sovereign downgrades also tend to happen during periods of global financial

turmoil, when even firms with access to global markets may find it difficult to

raise alternative sources of finance. Thus, the impact of sovereign downgrades

is often amplified by adverse market conditions.4

Our benchmark empirical specification employs the Abadie and Imbens

(2011) bias-corrected matching estimator of the AverageEffect of the Treatment

on the Treated (ATT). We first isolate firms at the sovereign bound (treated

firms). Then, from the population of firms below the sovereign bound (non-

treated firms), we look for control firms that best match treated firms along

multiple dimensions (country,year, size, investment, Tobin’s Q, cash flow, cash,

leverage, foreign sales, government ownership, and exposure to government

spending) before the treatment (sovereign downgrades).5

We find economically significant effects of sovereign rating downgrades.

First, treated firms’ investment decreases from 26.6% to 17.7% of capital in

the year of the downgrade, implying a 8.9 percentage point reduction. In con-

trast, control firms reduce investment by 2.6 percentage points, resulting in

a difference-in-difference estimator of −6.4 percentage points and an ATT of

−8.9 percentage points. The differential effects on investment are statistically

significant. Second, treated firms’ net debt issuance decreases from 7.5% to

3Our sample of bound (treated) firms includes 73 firms, so we have limited ability to split the

sample according to variables such as the likelihood of a change in capital requirements.

4Gande and Parsley (2005) show that sovereign downgrades have spillover effects on the credit

spreads of other countries. In our sample, most sovereign downgrades happened in the aftermath of

the Asian and Russian crises and the burst of the Internet bubble (end of the 1990s and beginning

of the 2000s), and following the financial crisis of 2007 to 2009. Thus, it may also be costly for firms

to issue debt in other countries.

5While we match perfectly on country-year, it is difficult to find industry matches in smaller

countries. Thus, our benchmark results use a sample of control firms that is not matched on

industry.We obtain similar estimates when we use a smaller sample for which we can find control

firms that match treated firms according to the Fama-French 12-industry classification.