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E-MailThe following post comes to us from John (Xuefeng) Jiang, Associate Professor of Accounting at Michigan State University; Mary Stanford, Professor of Accounting at Texas Christian University; and Yuan Xie, Assistant Professor of Accounting at Fordham University.
In our paper, Does It Matter Who Pays for Bond Ratings? Historical Evidence, forthcoming in the Journal of Financial Economics, we examine whether charging issuers for bond ratings is associated with higher credit ratings employing the historical setting wherein S&P switched from an investor-pay to an issuer-pay model in 1974, four years after Moody’s made the same switch.
Many commentators and policy makers claim that charging bond issuers for ratings introduces conflicts of interest into the rating process. For corporate bonds issued between 1971 and 1978, we find that, for the same bond, Moody’s rating is higher than S&P’s rating prior to 1974 when only Moody’s charges issuers. After S&P adopts the issuer-pay model in July 1974, the evidence indicates that S&P’s ratings increase to the extent that they no longer differ from Moody’s ratings. Because we use Moody’s ratings for the same bond as our benchmark, we can conclude that this increase in S&P’s ratings is not due to general changes affecting bond ratings.
Further, cross-sectional analyses show that S&P’s ratings increase only for bonds with greater potential conflicts of interest under the new revenue model, i.e., for bonds that likely pay higher fees or have greater incentives to attain a higher rating. For our sample, the average increase in S&P’s rating is approximately 20% of a rating category, which results in a reduction in yield spread of roughly 10 basis points. This translates into interest saving of $51,000 per year in 1974 or over $222,000 in 2010 inflation adjusted dollars. These results are consistent with bond issuers gaining bargaining power when they pay for ratings.
Although our sample period is historical, our inferences are consistent with two contemporary studies that compare different rating agencies and utilize recent data on ratings for mortgage-backed securities (Xia 2010, He, Qian, and Strahan 2011). Because we use Moody’s ratings for the same bond as a benchmark to compare with S&P’s rating and because we compare the two agencies’ ratings both before and after S&P adopts the issuer-pay model our research design presents a clean test of whether and how much the switch to the issuer-pay fee model influenced credit ratings in the past.
Overall, the evidence regarding firms that received different initial ratings from the two agencies indicates that the issuer-pay model leads to higher bond ratings, and that this increase in ratings derives from inherent conflicts of interest.
The full paper is available for download here.
