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The Impact of Rating Agency Reputation on Local Government Bond Yields

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J Finan Serv Res (2008) 33:57 76 DOI /s The Impact of Rating Agency Reputation on Local Government Bond Yields Arthur C. Allen & Donna M. Dudney Received: 20 June 2006 / Revised:
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J Finan Serv Res (2008) 33:57 76 DOI /s The Impact of Rating Agency Reputation on Local Government Bond Yields Arthur C. Allen & Donna M. Dudney Received: 20 June 2006 / Revised: 10 September 2007 / Accepted: 27 September 2007 / Published online: 10 November 2007 # Springer Science + Business Media, LLC 2007 Abstract This study examines a sample of 12,562 dual-rated local government bond issues including 6,104 split-rated issues to determine which rating agency has the greatest impact on yields. Using a database of municipal bond issues from 1986 to 2002, we show that Moody s rated significantly more issues than S&P, and that Moody s ratings were more conservative. However, from 1993 to 1997, there was a reduction in ratings disagreements and in Moody s market share. Beginning in 1995, Moody s received negative publicity related to a Department of Justice anti-trust investigation. Moody s appears to have responded by sharply increasing their relative conservatism in From 1986 to 1994, Moody s ratings had a greater impact on bond yields than S&P ratings, but their dominant influence on yields disappears in the recent sample period from 1995 to JEL classifications G12. G24 Keywords Split ratings. municipal bonds. rating agencies. reputation Investors look to bond ratings to provide guidance on the default risk of bonds. The literature suggests that ratings provide information to the market beyond the information found in published financial reports (Liu et al. 1999). Moody s and Standard and Poor s are the oldest and largest rating agencies and have well-established reputations among investors. Bond rating studies indicate that both agencies do a reasonable job of assessing relative credit risks, with lower-rated bonds defaulting more frequently than higher-rated bonds (Cantor and Packer 1995). A. C. Allen College of Business, School of Accountancy, University of Nebraska-Lincoln, Lincoln, NE , USA D. M. Dudney (*) College of Business, Department of Finance, University of Nebraska-Lincoln, P.O. Box , Lincoln, NE , USA DO21; No of Pages 58 J Finan Serv Res (2008) 33:57 76 While Moody s and S&P assign the same rating a majority of the time, in approximately 44% of the rated municipal issues from 1986 to 2002 the ratings assigned by Moody s and S&P were different. These differences could be attributed to differing rating criteria (or differing weights applied to similar criteria) or to random differences occurring in borderline cases. The differences could also be due to rating agency efforts to gain a competitive advantage with issuers or investors. Regardless of the reason for the split rating, the existence of splits provides an opportunity to analyze the relative reputations of the two dominant credit agencies. We examine 12,562 municipal issues (including 6,104 split-rated issues) to determine whether the pricing on primary market issues is more influenced by the S&P or the Moody s rating. Rating agencies earn revenue from issuers purchasing ratings for new issues, and from investors who subscribe to ratings publications and databases. In a competitive market, an agency may attempt to gain more market share among issuers by awarding higher ratings than competing rating agencies. Of course, if investors recognize that an agency is consistently more lenient, the agency s reputation among investors may suffer, and yields on bond issues rated by the agency will be adjusted upward to offset the rating inflation bias. Issuers consider both the cost of a rating and the impact of the rating on expected bond pricing when selecting a rating agency. Therefore, a rating agency s attempt to increase market share by using more lenient rating standards will be unsuccessful in the long run if detected by investors. However, it is conceivable that an agency with an established reputation could, in the short run, become more lenient relative to its competitors without incurring a market yield penalty. An agency may pursue this shortrun strategy to make up market share lost to competitors or to gain market share in targeted issuer segments. To examine the interplay between rating agency market share and the influence of rating agency reputation on bond yields, we analyze the time series behavior of 66,820 rated municipal bonds to see if changes have occurred in the relative influence, conservatism or market share of the dominant rating agencies. A change in these variables could occur because one agency develops a superior reputation for more accurate analysis, because of changes in relative leniency (perhaps motivated by an agency s short-run marketing strategies), or because of damage to the reputational capital of an agency. As an example of potential reputational damage, the rating agency practice of releasing unsolicited ratings on municipal issues was the subject of a highly-publicized Justice Department investigation of Moody s Investors Service in Moody s was accused of using the threat of an unsolicited rating to coerce issuers to purchase a solicited rating from Moody s. While this study is not a test of the effects of the Department of Justice investigation, we note that the events surrounding this investigation, including the negative publicity, may have contributed to a loss in market share and relative influence of a Moody s rating. Prior studies of the effect of split-ratings on yields offer evidence that both Moody s and S&P ratings provide useful information to the market, but generally conclude that neither agency has more influence in determining bond yields. However, most prior studies focus on the corporate bond market, and are characterized by small split-rating sample sizes. There are several unique features of the local government bond and rating environment that allow the municipal market to provide a stronger test of rating agency reputation. The municipal market differs from the corporate bond market in both the sophistication of the investors and the quality of issuer information. While institutional investors play a dominant role in the corporate bond market, the municipal market is characterized by less J Finan Serv Res (2008) 33: sophisticated investors. In September 2004, individual investors directly held 30% of outstanding municipal bonds, compared to 13% of outstanding corporate bonds. 1 In addition, as noted by Perry et al. (1991), information about municipal issuers is less readily available to investors because municipal issues are exempt from most disclosure and registration requirements. Compared to corporations, municipal financial accounting information is less standardized, less timely and less comparable cross-sectionally. These factors make it more difficult for investors to obtain reliable information about the credit quality of issuers. In this environment, we expect investors to rely more heavily on bond ratings, and to be more interested in the relative reputations of the agencies providing these ratings. When different ratings are assigned by the rating agencies, investors will place more weight on the rating assigned by the agency perceived to be more accurate and reliable, and will demand yields commensurate with the rating assigned by the more reputable agency. Moody s and S&P claim to rate virtually all issues of public corporate debt but make no such claim for local governments. Our analysis shows that a large percentage of all municipal issues are unrated by one or the other agency. Therefore, it is possible that one agency could rate more municipal issuers and become more experienced as well as more familiar to and trusted by bond buyers. Historically, Moody s has rated substantially more municipal issues than S&P, although its lead has been eroding. Because of the differences between the corporate and municipal markets, findings from the corporate split-rating studies cannot be generalized to the municipal bond market. Instead, the municipal market may provide a better setting to study the impact of rating agency reputation because municipal bond investors are forced to rely on ratings to a much greater degree than corporate bond investors. Understanding the value of ratings in the municipal market and the competitive forces that drive rating agencies will help issuers and investors alike make more informed decisions about choosing rating agencies and bond selection, respectively. Our study may also help future researchers construct more accurate models of ratings and bond yields. Our study has several additional advantages over prior studies of split-ratings. First, our sample contains virtually all of the dual-rated municipal bonds issued between 1986 and 2002, including 6,104 split-rated bonds. In the largest previous sample of split-rated government issues (135 split-rated issues), Hsueh and Kidwell (1988) analyze whether the market interest rate was influenced more by the higher or lower bond rating. However, their research design did not distinguish whether the higher rating assigned to an issue was a Moody s or S&P rating, and therefore could not determine which rating agency carried more weight. 2 Allen (1996) did distinguish between Moody s and S&P ratings, but his 1 For the period from 1980 to 2004, individual investor holdings of municipal securities have ranged from a low of 26.2% of total municipal holdings in 1980 to a high in 1990 of 48.5%. The holdings percentage declined gradually to 30.4% in 1998, and has since fluctuated between 30.9 and 35.8%. Data is from the Federal Reserve Statistical Release Z.1 Flow of Funds Accounts of the United States report for the third quarter of 2004, published by the Board of Governors of the Federal Reserve System (2004), and from the Bond Market Association Trends in the Holdings of Municipal Securites , online at www. bondmarkets.com. 2 An example of their split ratings variable was Aaa/Aa, where either the Moody s or the S&P rating could be the higher rating. Therefore, they could only draw inferences on whether the higher or lower rating was more influential. As discussed in the methodology section, we use two variables, Aaa/AA and AAA/Aa, for this type of split-rating, and therefore, our research design allows us to determine both whether the higher or lower rating is more influential and whether the Moody s or S&P rating is more influential. 60 J Finan Serv Res (2008) 33:57 76 results are based on monthly secondary market observations for just 91 split-rated bond issues. Local government studies that have addressed the relative influence of Moody s or S&P rating have employed very small sample sizes in each rating category. For example, Perry et al. (1988) analyze the influence of Moody s versus S&P ratings, but had only 54 split-rating observations using main rating categories. On average, each split-rating category contained only nine observations (54 total observations divided by six categories) when using main ratings 3. By comparison, we have an average of 678 observations per category (6,104 splitrated observations divided by nine main rating categories). Using a much larger sample increases the power of statistical tests, and allows us to examine whether Moody s or S&P ratings are more influential. Second, our data spans a longer time frame and includes more recent data ( ). This data allows us to examine trends in market share and conservatism of each rating agency, and to examine the relative influence of each rating agency on new issue yields. We find that Moody s rated far more issues than S&P over the sample period. However, ratings disagreements declined substantially from 1994 to 1996, and Moody s market share diminished substantially from 1993 to Beginning in 1993, Moody s received negative publicity related to a lawsuit filed against Moody s. This lawsuit was the genesis of a Department of Justice anti-trust investigation that began in Moody s appears to have responded to these events by sharply increasing their relative conservatism in Although Moody s did not recover their previously dominant market share, their relative market share stabilized beginning in For the period from 1986 to 1994, Moody s ratings had a greater impact on bond yields than S&P ratings, but their dominant influence on yields disappears in the recent sample period from 1995 to Because Moody s and S&P have been the dominant rating agencies in the municipal market, we choose to focus on dual-rated Moody s and S&P issues. However, because Fitch has been gaining market share in the municipal market, we also consider the impact of Fitch ratings. We find that while Fitch has substantially increased its market share, it continues to rate a much smaller number of new issues, and the addition of a Fitch rating to an issue already rated by S&P and Moody s generally does not significantly affect yields. Fitch tends to attract larger issuers, and Fitch ratings are generally purchased as a third rating in addition to the S&P and Moody s ratings. 4 1 Literature Review A substantial body of literature examines rating differences between agencies. Cluff and Farnham (1984) and Morton (1976) study the criteria used in determining municipal ratings and conclude that Moody s and S&P use different criteria or different weighting of the same criteria. Both agencies claim to consider four general categories of variables in determining ratings: the economic base, financial, debt, and administrative factors. However, Cluff and 3 Perry et al. (1991) had 54 split-rating observations using main rating categories and 97 observations using modified categories. On average, each split-rating category contained 5.39 observations (97 total observations divided by 18 categories) when using the modified categories. 4 The tendency for Fitch ratings to be purchased by larger issuers is not surprising since the cost of a rating per dollar issued is much smaller for larger issues. Given the small yield advantage associated with the purchase of a Fitch rating, only large issuers can achieve interest costs savings sufficient to warrant the purchase of a third rating. J Finan Serv Res (2008) 33: Farnham find that S&P tends to place more emphasis on economic and demographic factors while Moody s weights debt burden and other financial information more heavily. Given that the agencies appear to take different approaches to determining municipal ratings, several studies have examined the relative influence of the two major agencies. Ellis (1998) and Baker and Mansi (2002) surveyed issuers and institutional investors and found that investors rated S&P first in credibility, followed by Moody s. In the Ellis study, issuers placed Duff and Phelps and Moody s in a tie for second place behind S&P, while in the Baker and Mansi (2002) survey both issuers and investors assessed the ratings of Duff and Phelps and Fitch as less accurate than Moody s and S&P. In both studies, the average scores for Moody s and S&P were not significantly different, but the survey respondents primarily invest in corporate securities. With the exception of the survey work noted above, most studies of the relative influence of ratings from the two major agencies have examined yields on split-rated issues to see if these yields are consistently different from yields on dual-rated bonds with the same rating from both agencies. If yields differ, the studies test whether yields tend to track a particular agency s ratings. Previous research on the impact of split ratings on yields is summarized in Table 1. Three studies focus on the municipal bond market. Hseuh and Kidwell (1988) examine 1,512 Texas issues rated between 1976 and They find that yields on 135 split-rated bonds are not significantly different from yields on dual-rated bonds with a rating equal to the higher split-rating. When yields on split-rated bonds are compared to yields on dualrated bonds with a rating equal to the lower split-rating, yields on the split-rated bonds are significantly lower than yields on the dual-rated bonds. Using a 1983 sample of 250 general obligation bonds, and a sample of 55 split ratings, Perry et al. (1991) find that if modifiers are not included in bond ratings, split generic ratings do not affect bond yields. Difference in yields associated with modified rating splits are attributed to the lack of a one-to-one correspondence between Moody s and S&P s modified rating systems during the time period covered by the study. 5 Allen (1996) used monthly observations on 395 secondary market general obligation bonds from 1978 to 1987 and concluded that yields on split-rated bonds are in between those of congruently-rated adjacent categories. When ratings are split Aa/AAA or Aaa/AA, Moody s ratings have more influence in determining bond yields. Similar results are found for bonds rated Aa/A instead of AA/A. Results of split-rating studies on corporate bonds have been mixed. Comparing splitrated bonds with bonds receiving the same rating from both agencies, Billingsley et. al. (1985), Perry et al. (1988), and Liu and Moore (1987) find that yields on split-rated issues are not significantly different from yields on bonds with the lower rating from both agencies. In contrast, Jewell and Livingston (1998) find that yields on split-rated bonds are an average of the yields of the two ratings. Thompson and Vaz (1990) compare single-rated bonds to dual-rated bonds and find that two matching ratings reduce yields below those on bonds with the same rating from only one agency. In the Thompson and Vaz study, yields on split-rated bonds are significantly higher than yields on bonds with the higher rating from both agencies. Most corporate bond studies find that neither rating agency has more influence in determining bond yields (see Billingsley et. al. 1985; Ederington 1986; Liu and Moore 1987; Kish and Hogan 1999; and Jewell and Livingston 1998). Beattie and Searle (1992) find a very high correlation between Moody s and S&P ratings (0.97) for a 1990 sample of 5,284 corporate bonds. 5 Moody s began using a single modifier in each rating class in 1982, while S&P began using two modifiers in each rating class beginning in Moody s adopted a second modifier in 1996. 62 J Finan Serv Res (2008) 33:57 76 Table 1 Summary of prior split rating research. We report the authors, sample composition, type of market, and sample size. We summarize the authors findings including the rating agency with the largest influence on bond yields Authors Sample Market Number of split ratings Findings Which rating agency has more influence in determining bond yields? Hsueh and Kidwell (1988) Perry et al. (1991) Allen (1996) Billingsley et al. (1985) Ederington (1986) Liu and Moore (1987) 1,512 Texas GO bonds GO bonds December 1983 Monthly observations on 395 GO bonds from 1978 to industrial bonds industrial bonds from Jan to Dec corporate bonds from June 1984 Municipal primary Municipal secondary Municipal secondary Corporate primary Corporate secondary Corporate secondary 135 Purchase of a second rating lowers NIC (net of transactions costs) by 5.2 basis points. Yields on splitrated bonds are not significantly different from adjacent higher ratings category; are significantly lower than adjacent lower ratings category 97 Split generic ratings have no effect on bond yields. For modified ratings splits, no difference if Moody s used as base rating. If S&P used as base rating, superior ratings assigned by Moody s result in significantly lower yields Monthly observations on 91 split ratings Yields of split-rated bonds are in between those of congruently-rated adjacent categories 33 Yields on split-rated bonds are not significantly different from adjacent lower ratings category; are significantly higher than adjacent upper ratings category 63 No systematic differences between Moody s and S&P ratings. Split ratings represent random differences of opinion 150 Yields on split-rated bonds reflect the lower of the two ratings Not tested Moody s but probably due to lack
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