The purpose of this study is to see if charging bond issuers for credit ratings results in higher ratings. Since 2002, when Standard & Poor’s (S&P), Moody’s Investor Service (Moody’s), and Fitch failed to predict the bankruptcy of Enron and WorldCom, the three major credit rating agenciesStandard & Poor’s (S&P), Moody’s Investor Service (Moody’s), and Fitchhave been extensively criticized. The major rating agencies were once again chastised during the recent financial crisis for not providing correct ratings for subprime mortgage-backed securities. Many observers and officials say that rating agencies’ failure is caused by their issuer-pay revenue model, and that rating agencies should move to an investor-pay revenue model. For example, according to Martin Wolf, the Financial Times’ senior economic writer, “The fact that the payment scheme for credit rating organizations has remained unchanged is scandalous. They should be paid by buyers’ representatives, not by sellers.” (Wolf, 2009; Wolf, 2009). According to Ezra Klein of the Washington Post, “It’s difficult to envision raters being completely deaf to sellers’ needs as long as they’re paying for the ratings. The ratings must be funded by the buyers.” (Klein, 2009; Klein, 2009). According to a recent regulatory suggestion, a “To rating agencies, a “pay-for-performance” approach has been proposed (World Bank, 2009).
However, many people do not feel the issuer-pay mechanism is to blame. The Securities and Exchange Commission (SEC) claims that “While the issuer-fee model naturally creates the potential for conflicts of interest and ratings inflation, most experts believe that this conflict is manageable and that the credit rating agencies have effectively addressed it for the most part” (SEC, 2003, p. 23). Some claim that rating agencies’ reputations are at risk if they engage in any short-term opportunistic action. “We are in the integrity business,” says Moody’s (House, 1995, p. 245), while S&P goes even further, saying, “Our reputation is our business” (Tillman, 2007). The SEC agrees: “The value of a rating organization’s business depends entirely on investor faith in the integrity and reliability of its ratings, and no single fee or group of fees could be significant enough to threaten the organization’s future success” (SEC, 2003, p. 13).
To date, there is little empirical data to support either of these viewpoints, owing to the absence of variety in revenue patterns between major rating agencies since July 1974, when S&P shifted from investor-pay to issuer-pay. We examine changes in bond ratings around the time S&P adopted the issuer-pay model, four years following Moody’s adoption in October 1970, in an attempt to shed light on this issue. Because S&P and Moody’s implemented the issuer-pay model at separate times, we used a difference-in-differences study approach to see how the ratings of the identical bond varied under the two revenue models.
We find that, between 1971 and June 1974, when Moody’s charged issuers for bond ratings and S&P charged investors, Moody’s ratings are, on average, higher than S&P’s ratings for the same bond, using a sample of 797 corporate bonds issued between 1971 and 1978 and rated by both S&P and Moody’s. Between July 1974 and July 1978, when both S&P and Moody’s charge issuers for bond ratings, we find that Moody’s ratings are no longer higher than S&P’s. Further research indicates that the discrepancy in ratings between the two agencies reflects a spike in S&P’s ratings about 1974, rather than a change in Moody’s ratings. This result backs up the theory that the issuer-pay model results in higher bond ratings.
We also run cross-sectional analysis to see if S&P gives higher ratings to bonds with more possible conflicts of interest than to other bonds. To capture conflicts of interest, we use two proxies. First, because major and frequent bond issuers bring in more income to a rating agency than other issuers, when they start paying fees to S&P, these issuers are likely to have more bargaining power. Second, because Moody’s always costs issuers during our sample period, poor creditworthy bonds are more likely to receive their ratings with the influence of paying Moody’s directly inside each Moody’s rating class. We believe that once these bonds start paying S&P directly, they will be more likely to obtain higher ratings from S&P. These predictions are supported by our cross-sectional analyses, which demonstrate that the increase in S&P ratings following the introduction of the issuer-pay fee model happens primarily for bonds that are projected to generate greater fees and have weaker credit quality within their Moody’s rating group. S&P’s rating increase is typically 20% of a rating grade. This percentage essentially correlates to a ten-basis-point reduction in yield spread, which would save a company $51,000 per year in interest costs for the average bond issuance in our sample. Using 1974 as a benchmark, this interest savings equates to more than $222,000 per year in inflation-adjusted currency in 2010. Overall, evidence from corporations with varied beginning ratings from the two agencies suggests that the issuer-pay approach results in higher bond ratings, and that this rise is due to inherent conflicts of interest.
Our findings are similar with two recent studies that used recent data, despite the fact that our sample period is historical. Xia (2010) compares corporations rated by S&P, which costs issuers, with firms rated by Egan-Jones Rating Agency (EJR), which charges investors, for ratings issued between 1999 and 2009. On average, S&P gives higher ratings than EJR, especially for enterprises that are expected to pay greater rating costs. 1 Similarly, He, Qian, and Strahan (forthcoming) look at mortgage-backed securities issued between 2000 and 2006 and find that Moody’s and S&P give larger issuers better ratings, resulting in more business and greater fees. Our research adds to and complements the conclusions drawn in these publications by demonstrating that the issuer-pay model has an impact on credit ratings even in the 1970s. Furthermore, our difference-in-differences research approach is more effective at proving a causal link between the issuer-pay model and higher ratings. To begin with, we utilize Moody’s ratings for the identical bond as a comparison to S&P’s rating. Second, we compare the ratings of the two agencies before and after S&P implements the issuer-pay approach. As a result, our study design allows us to assess whether and how much the switch to the issuer-pay charge model affects credit ratings in the past.
Our research adds to a growing body of knowledge about how different institutional arrangements affect credit ratings. According to Pettit, Fitt, Orlov, and Kalsekar (2004, p. 1), “Most business schools barely mention credit ratings and rating agencies in passing, and they remain one of the most understudied components of modern corporate finance” (emphasis in original). The recent financial crisis has sparked a spike in study interest in credit rating agencies, particularly in terms of how the industry’s features influence its performance (e.g., Becker and Milbourn, 2011, Kisgen and Strahan, 2010). New competition, the SEC’s accreditation of rating agencies, and the agency’s income model, according to recent study, all have an impact on credit ratings.
While abandoning the issuer-pay model may be unrealistic, the SEC has the authority to force bond issuers to disclose the amount they pay rating organizations for ratings and other consultancy services. Investors may be alerted to potential conflicts of interest if such information is provided. This disclosure obligation is analogous to the SarbanesOxley (SOX) requirement that companies report both audit and non-audit fees paid to auditors. According to evidence in the accounting literature, the audit fee disclosure requirement increased the transparency of the relationship between firms and their auditors and reduced the focus of auditors on non-audit related services. A measure similar to this for bond rating organizations could improve transparency in the business.
The remainder of this paper is organized as follows: Section 2 explains why S&P and Moody’s ditched the investor-pay model in favor of the issuer-pay model; Section 3 explains the research methodology; Section 4 introduces the sample and presents the findings; and Section 5 discusses alternative explanations and the results’ robustness; and Section 6 concludes.
How do rating agencies score bonds?
Bond issuers are often examined by their own set of rating organizations to gauge their creditworthiness, just as people have their own credit report and rating published by credit bureaus. Moody’s, Standard & Poor’s, and Fitch are the three main rating organizations that assess the creditworthiness of bonds. Their assessment of the issuer’s creditworthinessin other words, its capacity to make interest payments and return the loan in full at maturitydetermines the bond’s rating and, in turn, the yield the issuer must pay to entice investors. To compensate investors for the increased risk, lower-rated bonds typically offer higher yields.
How do bond ratings affect investors?
(3) How do bond ratings affect investors? They understand the rating to mean that the higher the rating, such as BBB to AAA, the greater the bond’s investment grade status. The lower the risk rate, the higher the bond rating.
What are bond ratings used for?
A bond rating is a letter grade that shows the creditworthiness of a bond. These evaluations of a bond issuer’s financial health, or its ability to pay a bond’s principal and interest on time, are provided by independent rating services such as Standard & Poor’s and Moody’s.
What are the names of the three major bond rating agencies?
The Big Three Consulting Firms
- The worldwide credit rating industry is highly consolidated, with only three firms Moody’s, Standard & Poor’s, and Fitchcontrolling nearly all of it.
What exactly are AAA bonds?
Bonds with the highest level of creditworthiness are given the highest possible rating, AAA. AAA-rated bonds are issued by companies that can satisfy all of their financial obligations and have the lowest risk of default. Companies can also be given a AAA grade.
AAA is used by rating organizations such as Standard & Poor’s (S&P) and Fitch Ratings to identify bonds of the highest credit quality. Moody’s uses a similar ‘Aaa’ to indicate a bond’s top tier credit rating.
When the term “default” is used in this context, it refers to a bond issuer failing to pay an investor the principle amount of interest due. Because AAA-bonds have the lowest risk of default, they also have the lowest payback compared to other bonds with identical maturity dates.
Microsoft (MFST) and Johnson & Johnson (JNJ) were the only two corporations in the world to receive the AAA grade in 2020. (JNJ). AAA ratings are highly prized, and many corporations lost their AAA ratings during the 2008 financial crisis. Only four corporations in the S&P 500 had the AAA rating as of mid-2009.
What are ESG grading organisations?
Sustainalytics, MSCI ESGI, and ESGI are all leading ESG rating organizations that provide access to their data to provide investors with more transparency and to assist firms in improving their ESG policies.
What is the best rating agency?
The Big Three Credit Rating Organizations Moody’s Investor Services and Standard and Poor’s are among the leading firms. S&P and Fitch Group are market leaders in the (S&P) and Fitch Group, respectively. Moody’s and S&P are both headquartered in the United States, and they control 80% of the global market.
What do bond ratings represent and who are the rating agencies?
- Bond rating firms evaluate the creditworthiness of debt securities as well as their issuers.
- Standard & Poor’s Global Ratings, Moody’s, and Fitch Ratings are the three major bond rating organizations in the United States.
- Bond rating organizations supply market participants with important information and assist investors in reducing research costs.
- Bond rating companies were chastised early in the twenty-first century for issuing erroneous ratings, particularly for mortgage-backed securities.
What does it imply to have a BBB bond rating?
The BBB grade indicates that the danger of default is now minimal. Although the capacity to pay financial obligations is considered adequate, poor business or economic situations are more likely to erode it.