Electronic copy available at: http://ssrn.com/abstract=2254037 1 Do Credit Ratings Really Affect Capital Structure? Kristopher J. Kemper * University of Wisconsin-Eau Claire Ramesh P. Rao Oklahoma State University Abstract This paper revisits recent investigations into the role credit ratings play in the marginal financing behavior of firms. While it has long been documented that credit ratings may be an important determinant of firm capital structure policy, academics have only recently subjected this motivation to empirical scrutiny. We add to the brief existing literature by investigating the sensitivity of marginal financing behavior of firms to a number of attributes deemed to capture firms’ affinity to emphasize credit ratings in their financing behavior. Our results suggest that credit ratings are not a first order concern in capital structure decisions. 1. Introduction Until recently, the effect of credit ratings on capital structure had not been formally investigated. The motivation for the recent interest in this topic can be traced to Graham and Harvey’s (2001) survey paper that lists maintaining a credit rating as the second most important objective in a firm’s credit policy. Kisgen (2006, 2009) finds the credit rating-capital structure (CR-CS) model (i.e., firm capital structure policy is influenced by credit ratings) to be generally descriptive of how firms behave. We argue that the CR-CS motivation is more applicable to a subset of firms than to all firms generally. At a minimum, even assuming CR-CS applies to the average firm, we expect that its appeal will vary systematically across firms classified by certain firm-level attributes. We examine several attributes. First, we test the sensitivity to firms that are active, or likely to be active, capital market participants versus firms that are less active in capital * Department of Accounting and Finance, Schneider 300E, College of Business, University of Wisconsin – Eau Claire, Eau Claire, WI 54702. Ph: 715-836-3137. Email: kemperkj@uwec.edu Electronic copy available at: http://ssrn.com/abstract=2254037 2 markets. Second, we examine the sensitivity of the CR-CS model to the bond rating of the firm. That is, is an AA rated firm more motivated to take capital structure actions to maintain its rating than an A rated firm? Also, is a firm that is on the cusp of the investment/non-investment grade rating more motivated by CR-CS considerations than other firms? Third, we test the sensitivity of the CR-CS motivation to firms that are active in the commercial paper market compared to firms that are not. Lastly, we examine the capital structure behavior of firms as it relates to the investment opportunities available to these firms. We argue that firms with greater growth opportunities would be more likely to be concerned with maintaining or achieving a long-term rating. The foundation for this argument is that these firms are likely to be raising capital in the near future and would be interested in doing so at the lowest possible cost. We reconfirm Kisgen’s (2006) findings that firms at the edge of a ratings change have a propensity to use less debt at the margin, thus supporting the CR-CS model. However, we are unable to document that the CR-CS motivation is systematically related to any of the attributes listed above, which we argued should proxy for management’s inclination to adopt the CR-CS model. Especially damaging is the fact that the CR-CS model does not appear to hold across all rating classes. In fact, our analysis indicates that with the exception of B rated firms, firms in no other rating group seem to curtail debt financing when faced with the prospect of losing its rating. Thus, Kisgen’s original findings appear to be driven by the subsample of firms with extremely low ratings. This is weak evidence in support of the CR-CS model, especially given that B rated firms are generally associated with financial distress. Therefore, their marginal financing behavior to avoid debt may be more an indication of lack of access to the debt market than an indication of a conscious attempt to decrease debt financing. Additionally, the CR-CS model implies that firms on the cusp of the investment and non- 3 investment grade rating should be especially sensitive to the impact of their marginal financing behavior on their credit ratings. However, our results do not find this to be the case. With regard to the other attributes, our results are just as puzzling. We do not find that the CR-CS model is more applicable to firms that have external financing needs and firms that regularly access the capital markets, firms that access the commercial paper market, and high growth firms. These results lead us to conclude that the CR-CS model is not a good descriptor of how firms determine their marginal financing decision. We are careful to point out that this does not necessarily mean that firms and CFOs do not consider credit ratings to be an important determinant of their capital structure policy. Such a conclusion is hard to justify given that survey evidence indicates managers consider credit ratings to be one of the most important determinants of target capital structure. It is conceivable that there is too much noise in marginal financing data to obtain significant findings. It is also possible that firms on the verge of losing or improving their current ratings may use other tools at their disposal to maintain or improve their rating such as asset restructuring (e.g., asset sales, spin-offs) and operating cost changes (e.g., layoffs, outsourcing, offshoring). In this context it is important to note that other factors besides leverage also impact ratings including profitability, quality of assets, etc. 2. Literature review Most corporate finance textbooks recognize that credit ratings may influence capital structure policy in practice (e.g., Moyer, McGuigan, Rao, and Kretlow, 2012; Brigham, Gapenski, and Ehrhardt, 1999; and, Damodaran, 1997), but a formal investigation has eluded us until recently. In a landmark study of corporate financial practice, Graham and Harvey (2001) disclose that CFOs identified credit rating as the second most important factor affecting debt 4 policy (second only to “financial flexibility”). Using this survey as a motivation, Kisgen (2006) conducts one of the first formal tests of the CR-CS model. Kisgen argues that for credit ratings to have an independent effect on capital structure, there must be discrete shifts in the costs experienced by the firm across the various rating categories. He argues that an implication of the model is that “firms near a credit rating upgrade or downgrade issue less debt relative to equity than firms not near a change in rating.” Operationally this means that a firm with a Plus or Minus rating will be reluctant to issue debt at the margin. 1 The Plus and Minus designations serve as a signal that a firm is on the verge of a ratings change. The result, according to the CR- CS theory, is that firms on the edge should be reluctant to issue debt. A firm with a Plus rating would not want to sacrifice an opportunity to move into a higher credit rating by issuing debt; and a firm with a Minus rating would not want the credit rating agency to consider lowering its rating as a result of any new debt issues. In a follow-up study, Kisgen (2009) examines the financing behavior of firms that experience a ratings change. If firms do make capital structure decisions with credit ratings in mind, Kisgen says we should expect firms to take action in the form of capital structure adjustments following a downgrade. This adjustment would be a reasonable response to a credit rating change if the CR-CS hypothesis is correct. Consistent with the CR-CS hypothesis, Kisgen finds that firms issue less debt relative to equity in the year following a downgrade in rating, further supporting the findings in Kisgen (2006). However, no effect on firms with ratings upgrades is revealed. 3. Hypotheses development While the two Kisgen (2006, 2009) studies provide evidence consistent with the CR-CS motivation for financing behavior, they do not examine the sensitivity of the credit rating 1 According to S&P, the Plus and Minus ratings show the “relative standing within the major rating categories.” http://img.en25.com/Web/StandardandPoors/SP_CreditRatingsGuide.pdf 5 motivation to firm-level attributes. It will be interesting to know if the CR-CS hypothesis is valid across the broad spectrum of firms or if its appeal is limited to or conditional on certain attributes. Our basic thesis is that while all firms may have some desire to maintain or achieve a certain credit rating, that desire is likely more pronounced for certain types of firms. We identify several attributes which are deemed to be correlated with a firm’s likelihood to consider credit ratings in their capital structure decisions. We then explore if the validity of the CR-CS model as revealed by a firm’s marginal financing behavior is systematically related to these attributes. If a systematic relationship is found, this would further support previous findings suggesting credit ratings play a role in capital structure. We expect firms with significant external financing needs, and thus likely to be active capital market participants, to be concerned with their credit rating more than other firms. Also, firms that currently have an investment grade rating might be more interested in activities that would prevent it from becoming a "fallen angel" than firms that have already lost that status. Discrete costs associated with ratings changes are expected to be especially significant for firms on either side of the investment/non-investment grade threshold (i.e., BBB- and BB+ ratings). Firms that issue commercial paper are expected to be more interested in maintaining a credit rating in order to allow it to continue to finance parts of its operations with this type of security. Alternatively, firms that do not rely on commercial paper as a financing tool might be less likely to follow this theory. Finally, a firm with investment opportunities might be more interested in its credit rating than a firm with less investment opportunities for the simple reason that an unfavorable credit rating might inhibit its ability to fund these investments. 3.1 Hypothesis one: external financing needs and capital market participation We anticipate that firms with external financing needs, and therefore likely to be 6 actively engaged in the capital markets, are more sensitive to the CR-CS motivation. These firms are going to be more concerned with the discrete cost jumps associated with credit ratings in view of their need to tap the capital markets for new financing. The higher discrete costs associated with having to issue a bond at a higher than anticipated rate over time will be greater for a firm that has a greater need to visit the capital markets than one that relies on internal funding sources for its financing needs. In alternate form, our hypothesis is expressed as follows: H 1 : Firms that have greater external financing needs will be more likely to consider credit ratings in their capital structure decisions than firms that do not rely as much on external capital markets for their financing needs. 3.2 Hypothesis two: effect across bond ratings The CR-CS model implicitly assumes that firms care about their broad rating category regardless of the rating. This assumes that an AA- rated firm at the risk of losing its broad rating (i.e., AA) is as likely to modify its financing behavior to protect its broad rating as an A- rated firm. However, do some ratings drive firms to react more aggressively? This may especially be the case for firms on the cusp of the investment/non-investment grade rating. We expect that a firm threatened with the loss of its investment grade designation (i.e., BBB-) will more likely attempt to preserve its status. Likewise, a firm just below the investment grade rating (i.e., BB+) will likely make changes to its financing activity at the margin to enhance the likelihood of being “bumped” to the investment grade category. The discrete costs associated with a change in broad rating for these firms are likely to be more significant than for firms in other rating categories. As mentioned in Cantor and Packer (1997), regulators use credit ratings as a threshold to determine whether an institutional 7 investor may hold the debt of a certain company. Therefore, a firm that loses investment grade status will no longer attract institutional investors, as this is a critical regulatory hurdle. The loss of institutional investors can be quite costly to a firm due to discrete costs associated with the loss of this market. Kisgen (2006) cites the restrictions faced by banks in terms of their ability to hold the debt of non-investment grade firms. Due to concerns about bank stability and its role in a healthy and efficient market, federal regulations do not allow banks to take these speculative positions. Insurance companies, as noted by Kisgen, also face similar regulatory restrictions. Once again, a portfolio with speculative bonds is not deemed appropriate for this type of business, nor for pension funds. Kisgen also mentions the role credit ratings play in determining the capital requirements for broker-dealers, as dictated by the Securities and Exchange Commission. Simply put, regulatory restrictions favoring investment grade bonds imply that bonds that risk losing their investment grade status will have to offer a higher yield beyond that associated with an increase in default and liquidity risk. The higher discrete costs associated with the loss of an investment grade status suggests that the CR-CS model is especially relevant for firms on the cusp of losing their investment grade status. 2 We test the following related hypotheses with respect to the sensitivity of the CR-CS motivation to bond ratings: H 2a : CR-CS motivated financing behavior varies systematically across the various bond rating categories. H 2b : CR-CS motivated financing behavior applies more strongly to firms at the investment/non-investment grade threshold than to other ratings classes. 2 For more information on regulations and credit ratings, see Kisgen (2006, p. 1037-8). 8 3.3 Hypothesis three: commercial paper issuers We examine the sensitivity of the CR-CS model to commercial paper issuers. Regular participants in the commercial paper market are expected to be especially sensitive to maintaining their bond ratings. Commercial paper 3 is an unsecured note issued by corporations for short-term funding. The maturity for this type of security is less than 270 days and the resulting funds have a variety of uses, such as payroll and financing inventory. These issues are not typically backed by any specific collateral. Therefore, lenders rely on the financial strength and financial quality of the firm to signal an ability to repay this obligation. Firms are interested in this type of financing because it typically costs the firm less than a bank loan. Investors like commercial paper because the return is higher than the return on a U.S. Treasury bill with only a marginal increase in default risk. Financing through commercial paper is so popular that it exceeds Treasury bills in terms of issuance. Using information provided by the Securities Industry and Financial Markets Association, Kacperczyk and Schnabl (2010) note that short-term debt financing in the U.S. was approximately $5 trillion in 2007. Of this, $1.97 trillion was commercial paper while $940 billion was U.S. Treasury bills. 4 A firm that is financially distressed would be unable to attract investors and, in turn, unable to borrow short-term using this low-cost type of security. In addition, the rating of a firm's commercial paper has an effect on the type of investors who will supply funds. For example, a financial intermediary such as a mutual fund might be handcuffed by regulations detailing the quality of commercial paper that is suitable for investment (Cantor and Packer, 1997). 3 See Anderson and Gascon (2009) for a detailed discussion about the history of commercial paper, among other things. 4 Other short-term instruments mentioned by the Securities Industry and Financial Markets Association were time deposits, repurchase agreements, short-term notes and bankers’ acceptances. 9 Therefore, firms that borrow short-term through the use of commercial paper should be very interested in maintaining their credit rating. If the long-term rating is compromised, a firm will either lose its ability to borrow using commercial paper, may suffer liquidity issues, or may have to pay higher rates in the commercial paper market. For example, in 2009 Prudential Financial Inc. lost its eligibility for a US commercial paper program after Fitch downgraded their short-term debt. This occurred shortly after other industry members (Hartford Financial Services Group Inc. and Genworth Financial Inc.) experienced the same fate. Fitch noted that the downgrade was due to investment losses and questioned the firm’s immediate financial flexibility. 5 We expect to find that firms that issue commercial paper will be more likely to make capital structure decisions with credit ratings in mind than an otherwise equivalent firm. In alternate form, our testable hypothesis may be stated as: H 3 : CR-CS motivated financing behavior applies more strongly to firms that issue commercial paper compared to those that do not. 3.4 Hypothesis four: growth opportunities A firm with investment opportunities may be more interested in maintaining a credit rating than a firm that does not have the same opportunities. Growth firms are more likely to have positive net present value (NPV) projects available. Therefore, funding becomes a core concern for a growth company making this subset of firms a more likely visitor to the capital markets. As a result, the cost of new funds will be a function of the firm’s current rating and will affect the ability to grow. We state the final hypothesis in the following alternate form: 5 http://www.bloomberg.com/apps/news?pid=newsarchive&sid=amgmS0NBYhIc&refer=home 10 H 4 : CR-CS motivated financing behavior applies more strongly to firms with greater investment growth opportunities. 4. Methodology Our test methodology is an adaptation of Kisgen (2006). Kisgen tests the basic hypothesis that firms at the edge of a broad rating category (Plus or Minus rating within a broad rating, e.g., A- or A+) will be reluctant to issue additional long-term debt. The Minus rated firms are reluctant to issue additional debt at the margin because of the potential for risking their broad rating, while the Plus rated firms do so because it would enhance their potential to move up to the next broad rating class. The test is conducted by way of estimating a regression model with debt issuance as the dependent variable (NetDIss) and a credit rating dummy variable to capture how close the firm is to losing its current broad rating designation. The dummy variable captures whether the firm has a Plus or Minus in its bond rating. Kisgen runs estimates using a combined dummy variable (POM) and one that is decomposed into Plus and Minus categories separately (Plus, Minus). In addition to these variables of interest, Kisgen also includes several control variables. The regression models along with variable definitions are as follows:             (1)                  (2) Where: NetDIss it = (D i,t - E i,t )/A i,t . D it = book long-term debt plus book short-term debt for firm  at time  (Compustat data item 9 plus data item 34). D it = long-term debt issuance minus long-term debt reduction plus changes in current debt for firm  from time  to    (Compustat data item 111 minus data item 114 plus data item 301). [...]... decision We are careful to point out that this does not necessarily mean that firms and CFOs do not consider credit ratings to be an important determinant of their capital structure policy Such a conclusion is hard to justify given survey evidence indicating that managers consider credit ratings to be one of the most important determinants of target capital structure It is conceivable that there is too... examined separately 22 by examining certain subsets of firms that are more or less likely to follow a capital structure policy that considers credit ratings The results here are in stark contrast to previous findings (Kisgen, 2006; 2009) which suggest that firms make capital structure decisions with credit ratings in mind Kisgen (2006) finds that consistent with the CR-CS model, firms on the verge of losing... most concerned about maintaining or achieving a certain credit rating Hence, these firms would be even more cautious than otherwise similar firms without the same opportunities when making marginal financing and capital structure decisions The results do not support this hypothesis, calling into question the role of credit ratings in capital structure decisions Our evidence suggests that for high Q... Table 3 Credit rating impact on capital structure decisions by capital market exposure – sensitivity to external financing needed and debt issuances This table presents coefficients and t-statistics for pooled time series regressions of net debt raised in a year (NetDIss) on credit rating variables and control variables The credit rating used is Standard & Poor’s Long-Term Domestic Issuer Credit Rating... Commercial paper during the financial crisis of 2007-2009, Journal of Economic Perspectives 24, 29-50 Kisgen, D.J., 2009 Do firms target credit ratings or leverage levels?, Journal of Financial and Quantitative Analysis 44, 1323-1344 Kisgen, D.J., 2006 Credit ratings and capital structure, Journal of Finance 61, 1035-1072 Lang, L.P., E Ofek and R.M Stulz, 1996 Leverage, investment, and firm growth,... 3,310 22,156 22,156 Table 2 Credit rating impact on capital structure decisions - replication of Kisgen (2006) with updated sample This table presents coefficients and t-statistics for pooled time series regressions of net debt raised in a year (NetDIss) on credit rating variables and control variables The credit rating used is Standard & Poor’s Long-Term Domestic Issuer Credit Rating as reported in... moderated by a firm’s growth prospects In other words, investment opportunities do not influence a firm’s decision to follow a capital structure policy with credit ratings in mind A potential explanation for this result is that firms with growth options are not concerned with their rating because investment opportunities trump credit ratings when pursuing the goal of maximizing shareholder wealth A firm with... the 1%, 5% and 10% levels, respectively 28 Table 4 Credit rating impact on capital structure decisions by rating This table presents coefficients and t-statistics for pooled time series regressions of net debt raised in a year (NetDIss) on credit rating variables and control variables The credit rating used is Standard & Poor’s Long-Term Domestic Issuer Credit Rating as reported in Compustat and includes... levels, respectively 29 Table 5 Credit rating impact on capital structure decisions - commercial paper issuers versus non issuers This table presents coefficients and t-statistics for pooled time series regressions of net debt raised in a year (NetDIss) on credit rating variables and control variables Credit rating used is Standard & Poor’s Long-Term Domestic Issuer Credit Rating as reported in Compustat... indicates that commercial paper issuers do not make capital structure decisions with long-term credit ratings in mind In fact, it appears non issuers of commercial paper may have some affinity to the CR-CS theory But this evidence is weak since for this subset, while POM is negatively significant, the significance appears to be driven by the Plus and not the Minus ratings Our evidence suggests that the . experience a ratings change. If firms do make capital structure decisions with credit ratings in mind, Kisgen says we should expect firms to take action in the form of capital structure adjustments. into the role credit ratings play in the marginal financing behavior of firms. While it has long been documented that credit ratings may be an important determinant of firm capital structure policy,. maintaining a credit rating as the second most important objective in a firm’s credit policy. Kisgen (2006, 2009) finds the credit rating -capital structure (CR-CS) model (i.e., firm capital structure