Credit ratings can shape corporate financial decisions

Credit Ratings Can Shape Corporate Financial Decisions - McCombs News and Magazine

When Moody’s altered a rating policy, it made some companies look less risky — and led them to take on more debt

Based on the research of Cesare Fracassi

On the surface, credit rating agencies simply score a company’s financial health. They look at a business’s equity and debt and diagnose how risky it is for investors. They slap on a letter grade to show how likely it is to repay its debts.

Sometimes, agencies play a less visible but more active role in corporate affairs, according to new research from the McCombs School of Business at The University of Texas at Austin. Cesare Fracassi, associate professor of finance, shows that by defining a company’s risk level, agencies can sway some of its business decisions.

With Gregory Weitzner of McGill University, he found when Moody’s reclassified some securities on companies’ balance sheets, it prompted them to borrow an average 22% more — perhaps because they could do so without hurting their credit ratings.

“They raised more debt, and they increased their investments, even though financially, nothing really had happened to the companies,” Fracassi says.

Gray Zone Securities

From a distance, credit ratings decisions can look cut and dried. Moody’s determines how likely it is that a company will default.

One key criterion is a company’s ratio of debt to equity, known as leverage. The more it’s weighted toward debt, the greater its chance of defaulting on that debt.

But there’s a gray zone of securities that falls between debt and equity. Moody’s decision involved one kind, called preferred equity or preferred stock.

Resembling a bond because it pays a fixed dividend, it is akin to a fixed interest rate. But unlike a bond, it doesn’t have to be paid back. Even if the company skips paying the dividend, it cannot trigger default.

“It looks like debt, but it also looks like equity,” Fracassi says.

Should it count as debt or equity? Previously, rating agencies counted half as debt and half as equity, 50-50.

But in July 2013, Moody’s changed that rule for companies below investment grade, meaning they were already rated as risky. Instead of 50-50, it classified their preferred stock as 100% equity.

By appearing to increase equity and decrease debt, those companies suddenly seemed more sound — although nothing changed in their operations or balance sheets. Fracassi wondered: How would they react to their improved financial status?

Doubling Down on Debt

Of 475 companies rated below investment grade, 44 had preferred stock on their balance sheets. That allowed Fracassi to compare companies affected by the switch with ones that were not.

Overnight, he found, companies with preferred stock became “safer” to Moody’s. Their average leverage dropped from 61.9% to 57.1% — equivalent to boosting their credit ratings one notch.

By raising their creditworthiness, the move also gave them room to borrow billions more. They did, funneling much of the extra money into growth. During the rest of 2013, compared with other companies, the affected ones:

Increased their overall leverage by an average 3.1 percentage points.

Boosted their assets and equipment 8%.

Saw their stock prices rise 2.8%.

For corporations, Fracassi can’t say whether the decision was good or bad overall. It improved value for shareholders, but it decreased value for debt holders.

But there’s a lesson for investors, he adds. After the 2008 financial crisis, credit rating agencies were criticized for underreporting risk and overrating some securities, such as those backed by subprime mortgages. His new research offers another reason to look beyond ratings and dig into the underlying financials.

“You may want to look at how companies make their decisions, without relying too much on rating agencies,” Fracassi says. “Investors should do their due diligence.”

“What’s in a Debt? Rating Agency Methodologies and Firms’ Financing and Investment Decisions” is published in Review of Corporate Finance Studies.

Story by Hope Reese

About this Post

Categories: Research and Insights, Featured News

Topics: Finance

Departments: Finance

Featured Faculty: Fracassi, Cesare

Sources: Big Ideas

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