Split Credit Rating Attribution – Beyond Rating Scales and Credit Metrics

In this study we determine that much more than differences in the rating scale are responsible for split credit ratings on corporate debt issues. We find that about one-third of the bond split ratings are due to the differences in ratings scales, while the remaining two-thirds are due to the following reasons. The nature of split-ratings implies that at least one of the following situations exists: (a) that one of the rating agencies has a more aggressive business focus to rating issues or (b) the split rating is due in large measure to additional factors that are not clearly measured by most credit metrics, such as values placed on intangible assets, R&D, currency, taxation and the impact of derivatives. Moreover, these variables result in stress test results with significant dispersion and lag effect from disclosure date to any credit rating adjustment that may occur. Somewhat surprisingly, testing resulted a statistically significant level of issues rated by Moody’s receive the higher credit rating relative to those of Standard & Poor’s. We also conducted a review of the rating process for Fitch, Egan Jones and A.M. Best with respect to split credit ratings which are found to be somewhat more conservative than the “old line” agencies. Investors use bond ratings to measure the riskiness of bonds, and they accordingly make their investments in a firm's securities. Firms are influenced by bond ratings, which affect the firm's access to capital and its cost of capital. Two major agencies, Moody's and Standard & Poor's dominate the market in rating bonds.The two rating agencies disagree substantially on the ratings for a particular issue or company. Split ratings have major financial implications. Regulators restrict many investment firms from investing in securities that do not receive investment ratings from at least two major rating agencies. While examining the financial implications of bond ratings, Billingsley et al. (1985) and Liu and Moore (1987) argue that investors pay more attention to the lower of the two ratings. Hsueh and Kidwell (1998) and Reiter and Ziebart (1991) contend that the higher of the two ratings sets market prices, whereas Jewell and Livingston (1998) affirm that both higher and lower bond ratings have an impact on bond prices and underwriter fees. We find that the higher of the two ratings reflect short-term market prices, while long-term investors pay more scrutiny to the lower of the two ratings. Credit rating notching policy and potential conflicts of interest: John and Ravid (2010) studied the relative valuation of senior versus subordinated debt with emphasis highlighting the institutional practice known as "notching," adopted by both S&P and by Moody's. According to S&P, "Notching policy primarily intends to reflect the relative recovery prospects of different instruments issued by the same issuer". Their study found that approximately 55% of all corporate debt issues have split ratings, primarily a one notch differential 42%, with two notches comprising 10% and three or more notches amounting to roughly 2%. The yield difference ranges from 3 basis points to 5 basis points for investment grade paper while speculative issues range from 10 basis points to 15 basis points. Given applicable duration for debt issues this translates into a price differential based on notching policy of 0.20% and 0.60% for investment grade and high-yield issues respectively. The S&P approach is to notch up secured debt from the company credit rating and notch down subordinated debt. The company credit rating, as stated by S&P, corresponds to senior unsecured obligations. Moody's also notches up secured debt. Moody's has typically rated subordinated debt at least one notch below senior debt for investment grade issues and up to three notches for issuers with speculative grade senior debt. John and Ravid point out that in a 2000 publication Moody's suggested that absent any other information, subordinated debt is generally rated one notch below its senior unsecured rating. They also state that rating agencies apparently try to manage potential conflicts of interest by tending to overrate subordinated bonds with a low probability of default and underrate bonds with a high probability of default.Split and crossover credit ratings: When split rating situations exist and pricing models rely on either the higher, lower or average rating bias is introduced. Split bond ratings indicate that rating agencies cannot agree with each other on their assessment of the issuing firm. Absent that, the rating agencies may have different perception of possible fall-out from anticipated downgrade from investment grade BBB threshold to BB status. Moreover, when a firm becomes materially impaired and its debt rating is downgraded, it may trigger bond indenture covenant breach and if the likelihood that its stock information opacity plays a significant role in the value will crater. While questions of potential agency problems between rating agencies and firms they provide ratings on is beyond the scope of this paper, we do wish to stress that split ratings for issues, particularly when the firm withholds information and the company has bond issues outstanding at both the holding company and subsidiary level. Information opacity has been measured by several proxies including firm size, intangible assets, and dispersion of analysts’ forecasts.If split ratings are a signal of information opacity, then split rated bonds are expected to have higher yields than non-split rated bonds of similar default risk in order to compensate investors for the greater information opacity. This situation would generally be magnified for crossover credits straddling the line between BBB and BB ratings and even more so for convertible debt issues.Crossover credit relates to a bond that straddles the gap between investment-grade and speculative. Crossover credits are generally rated low investment grade by one rating agency and speculative grade by another rating agency. Therefore, a crossover credit is far more sensitive to rating changes than other split rated issues due to the stigma of being deemed a speculative grade issue. Investment policy guidelines for many funds mandate that their investments are solely in investment grade securities. Moreover, in recent years several other rating agencies such as Fitch and Egan-Jones have provided credit ratings that can either add value to credit analysis or compound the ambiguity surrounding split credit ratings, particularly involving crossover credit. It remains to be seen whether the different business model approach by these additional firms results in alleviating some of the information opacity that results in split ratings. Split ratings including crossover credits are found to be less common during economic recessions, and the information opacity premiums for split rated bonds are much higher during such times. These recessionary patterns indicated greater risk aversion for investors, difficult access to the capital market for firms with significant information opacity, and higher yield premiums during these periods. Such anomalies support the “financial accelerator” models of Bernanke, Gertler, and Gilchrist (1996).