Journal of Credit Risk

Risk.net

Issuer bias in corporate ratings toward financially constrained firms

Mohammad (Nazmul) Hasan, Nikunj Kapadia and Akhtar Siddique

  • The feedback effect of a rating downgrade may adversely impact the firm.
  • Using Moody's issuer ratings over 1982-2009, we show that firms with greater external financing constraints are less likely to be downgraded, especially in times when economy-wide credit spreads are high. The bias towards financially-constrained firms is robust and economically significant.
  • Our findings indicate that the rating agency accounts for the feedback effect in determining ratings.

Rating downgrades can have adverse consequences on a firm due to the feedback effect, even when ratings lack informational content. In this paper, we consider whether the rating agency attempts to mitigate the feedback effect through its rating actions. Using Moody’s issuer ratings over 1982–2009, we show that firms with greater external financing constraints are less likely to be downgraded. The issuer bias is robust, and its economic significance increases at times when economy-wide credit spreads are unusually high. We document that severely constrained firms whose ratings are affirmed or upgraded have long-term positive excess equity returns.

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