What information do credit ratings contain? Given their role of reducing information asymmetries between borrowers and lenders, we naturally expect them to be informative. However, defaults of highly-rated issuers and perceived conflicts of interest lead to concerns about the rating agencies’ incentives to make ratings informative. If information in credit ratings affects the allocation of capital, understanding the rating agencies’ incentives to reveal that information is important for optimal design of the ratings sector.
In this paper, I suggest that a previously overlooked competitive channel influences the informativeness of corporate bond ratings. I present a model in which a monopolistic rating agency faces a threat from private lenders targeting high-quality debt issuers. Arms-length public investors know only the issuer’s rating, while private lenders can learn the issuer’s quality but require a higher return.
The rating agency chooses the fee and informativeness of the rating, trading off low quality issuers’ desire to pool against the threat that high-quality issuers may borrow from private lenders if ratings do not allow them to separate. High-quality customers’ defection affects the rating agency directly through lost revenue from these customers, and indirectly by reducing the value of ratings for all customers. This externality operates through beliefs about rated issuer quality, and links the informativeness of credit ratings to the threat from private lenders.
I measure informativeness based on the estimated coefficient on the credit rating from a regression of the yield spread for a new issue on the rating and a set of issue- and issuer-level control variables. This measure of informativeness is based on the premise that when ratings contain information relative to what investors know, investors pay more for a bond issue that is rated higher than expected. By contrast, uninformative ratings have a lower impact on bond pricing.
I regress yield spreads on credit ratings and control variables and find that, on average, the rating determines over 10% of the yield spread for new issues. To address concerns about unobservable firm-level variables correlated with both ratings and access to capital, I control for the issuer’s previous rating. As a result, the coefficient on the rating measures the impact of a change in the unpredictable component of ratings on the borrowing cost of the issuer. This approach isolates investors’ beliefs about the informativeness of ratings at the time a bond is issued, assuming that investors understand the rating agency’s incentives.
