University of Amsterdam Amsterdam Business School Master in International Finance
Master Thesis
Impact of Sovereign Debt Downgrades on Firm Value
Themudo, Alan
September 2017
Abstract
This research paper will attempt to look into the effect of sovereign credit rating downgrades on firm value. It identifies causal effects by exploiting the effects of sovereign downgrades on corporate ratings due to rating agencies. Sovereign credit rating downgrades lead to greater decreases in investment and leverage of firms that are at the sovereign rating bound, relative to similar firms below the bound. Findings suggest that public debt management generates negative externalities for the private sector and real economic activity. Many governments normally seek credit ratings in order to ease their own access to international capital markets. While we find that sovereign ratings events have a significant impact on asset return
distributions during normal times, once we control for the influence of national market attributes, the effects are not heightened during episodes of financial crisis.
Table of Contents
1 Introduction……….2
2 Background and Related Literature………6
3 Data………...9
3.1 Selection of Countries and Indices………13
3.2 Equity Price Returns……….13
3.3 Time Periods……….18
4 Methodology | Empirical Analysis……….………...18
5 Results and Findings……….19
5.1 US Only………19
5.2 Non US………..23
5.3 Combined………..25
1 Introduction
Sovereign credit rating downgrades have become a significant problem for developed countries in the aftermath of the 2007-2009 global financial crises and the euro zone sovereign debt crisis.
Sovereign Credit rating is an evaluation of credit worthiness of a debtor especially a business or a government. The evaluation is made by a credit rating agency of the debtor’s ability to pay back the debt and their likelihood to default. The sovereign credit rating of a country gives potential investors insights into the level of risks associated with investing in a specific given country and would include political risks.
An insight into countries such as France and the United States shows that they were downgraded from AAA for the first time in history. Other developed countries including Greece, Ireland, Italy, the Netherlands, Portugal, and Spain also experienced downgrades.1
Firms are normally downgraded not because of a deterioration of their fundamentals, but simply because of the sovereign ceiling. Credit ratings are among corporate managers’ major concerns due to discrete costs and benefits that are associated with the different ratings levels (Kisgen (2006, 2007) and Kisgen and Strahan (2010)).
1 The sovereign credit rating of a country gives potential investors insights into the level of risks associated with investing in a specific given country and would include political risks.
First, ratings will most likely affect a firm’s access to the bond and commercial paper markets because rating levels determine whether some institutional investors such as banks or pension funds will be allowed to invest in a firm’s securities. Second, ratings affect the capital requirements that banks and insurance companies are subject to when investing in specific firms. Third, ratings convey information to the market about a firm’s credit quality. If investors pool firms by ratings, a rating change could result in changes in a firm’s cost of capital. Fourth, rating downgrades can trigger events such as bond covenant violations, increases in bond coupons or loan interest rates, and force bond repurchases.
Finally, ratings can impact on customer and employees’ relationships and business operations such as the ability to enter or maintain long-term supply and financial contracts. Because of these effects, firms appear to react to ratings downgrades by significantly reducing debt issuances and leverage (Kisgen (2009)).
Using the United States as an example we get to see that tax revenues are used to pay costs of government operations including military, healthcare, pensions, and other items but, most importantly for this research, to pay down sovereign debt obligations. As tax revenues
decrease during a recession, other costs remain constant and thus the ability to pay off debts is challenged. Therefore, we can see the credit rating for a given country as an economic pulse or health check. Sovereign debt downgrades create exogenous variation in firm equity value. In periods when financial markets operate normally, these financial policy changes may not spill over into real decisions and economic activity. But years of sovereign downgrades are far from normal. Local financial markets are likely being in trouble, so it is difficult for
downgraded firms to substitute debt for equity issuance.
Sovereign downgrades also tend to happen in periods of global financial turmoil, and so even firms that have access to global markets may find it difficult to raise alternative sources of finance. Thus, the impact of rating downgrades is amplified by adverse market conditions and
can change real outcomes as well. Sovereign rating downgrades also affect corporate bond yields.
Factors that could be used in the determination of sovereign ratings include:
• Per capita income: This always reflects to the tax base of the borrowing country, the greater
the income, the greater the ability of a government to repay debt. It refers to the total income of a country divided by the total population.
• GDP growth: It is among primary indicators used in gauging the health of an economy. A
relatively high rate of GDP growth suggests that a country’s existing debt burden will become easier to service over time. It is the monetary value for all goods and services produced in a country during specific time period.
• Inflation: A high rate of inflation points to structural problems in the government’s finances.
When a government appears unable or unwilling to pay for current budgetary expenses through taxes or debt issuance, it must resort to inflationary money finance. Public dissatisfaction with inflation may in turn lead to political instability.
• Fiscal balance: This is the amount of money government has from tax revenue and proceeds
savings and suggests that a government lacks the ability or will to tax its citizenry to cover current expenses or to service its debt. 2
• External balance: A large current account deficit indicates that the public and private sectors
together rely heavily on funds from abroad. Current account deficits that persist result in growth in foreign indebtedness, which may become unsustainable over time.
• External debt: A higher debt burden should correspond to a higher risk of default. The weight
of the burden increases as a country’s foreign currency debt rises relative to its foreign currency earnings (exports).
• Economic development: Although level of development is already measured by our per capita
income variable, the rating agencies appear to factor a threshold effect into the relationship between economic development and risk. That is, once countries reach a certain income or level of development, they may be less likely to default.6 We proxy for this minimum income or
development level with a simple indicator variable noting whether or not a country is classified as industrialized by the International Monetary Fund.
• Default history: Other factors held constant, a country that has defaulted on debt in the recent
past is widely perceived as a high credit risk. Both theoretical considerations of the role of reputation in sovereign debt and related evidence indicate that defaulting sovereigns suffer a severe decline in their standing with creditors (Ӧzler 1991). We factor in credit reputation by
2 Basel rules rely on external agency ratings to determine risk weights for the purpose of banks capital requirements for credit risk and such risk-weighting can affect the supply of capital to firms.
using an indicator variable that notes whether or not a country has defaulted on its international bank debt since 1970.
To summarize, this paper examines the effect of a sovereign debt rating downgrade
announcement on firms. This research also aims to add direction for investors during events of this type since these events cause impacts on the equity markets. I will attempt to show that rating downgrades would lead to an increase in the cost of capital, causing firms to deleverage and cut investment. Second, we provide an exact channel through which sovereign rating downgrades produce real effects. Sovereign downgrades cause corporate rating downgrades because of the sovereign ceiling rule, and the impact of these rating downgrades is amplified by adverse market conditions associated with the sovereign downgrade.
2 Background and Related Literature
There are multiple papers that examine the effects of sovereign debt downgrades. The research has ranged from impacts of ratings upgrades and downgrades on stock market indices and exchange rates. Also, the impact on the credit supply especially for European banks. Rating agencies have been assessing companies since 1961 when Standard & Poor’s set its first for sovereign states (Brooks (2004)).
Brooks et al (2004) examines the effects of sovereign ratings changes on the national markets, the paper found that rating downgrades have a significant negative impact on the event day and that rating upgrades have little indication of abnormal returns. This paper also studied the
wealth impact of rating downgrades and found that there does not seem to be an equal impact between upgrades and downgrades of sovereign debt. One main point, which will help steer the focus of this paper, Brooks et al (2004) found that only Standard & Poor’s and Fitch are found to cause significant market reactions, however, Standard & Poor’s rating agency has been rating sovereign debt the longest and that those create the largest market reactions when an announcement is released.
Also, it was found in this paper that reactions to Standard & Poor’s downgrades are more statistically significant than that of Fitch. Basel rules rely on external agency ratings to determine risk weights for the purpose of banks capital requirements for credit risk and such risk-weighting can affect the supply of capital to firms.3
While this paper focuses on sovereign debt downgrades, research has been done by Brooks (2004) on sovereign debt upgrades. In general, it has been found by numerous papers that upgrades have no impact on the stock and bond market (see Barron, Clare, and Thomas, 1997; Cornell, Landsman and Shapiro, 1989; Ederington and Goh, 1998; Goh and Ederington, 1993, 1999; Griffin and Sanvicente, 1982; Holthausen and Leftwich, 1986; Impson, Karafiath and Glascock, 1992; Liu, Seyyed and Smith, 1999; Matolcsy and Lianto, 1995; Wansley, Glascock and Clauretie, 1992; Zaima and McCarthy, 1988).
Baum et al (2014) examines the effects of rating downgrades on the value of the euro and the yields of the French, Italian, German, and Spanish long-term sovereign bonds during the time of the Eurozone debt crisis in 2011-2012. This paper explores the existence of contagion
3 Downgrades have a significant negative impact on the event day and that rating upgrades
while Italian, Spanish, and French bonds were downgraded their yields increased while Germany’s bond yields decreased although their rating was never adjusted by the agencies. Although Germany did not move, other Eurozone countries did and this caused downward pressure on the euro value. Kraussl (2005) shows that negative ratings significantly increase an index of speculative market pressure which consists of daily nominal exchange rate changes, daily short-term interest rate changes and daily stock market changes.
Almeida et al (2013) also explores the real effects of credit ratings during sovereign
downgrades by examining the effects on firm’s credit ratings and previous regulations set by credit rating agencies. This explores the effects on capital supply and structures. It states that a firm’s credit ratings are one of the top concerns for management teams. A downgrade in a firm’s credit rating can affect a firm’s access to the bond and commercial paper markets because of regulations set by institutional investors (Boot, Milbourn, and Schmeits (2006)) Previously, no firm could have a higher credit rating than that of the country it was based in (Tang (2009)). In 1982, Moody’s made a modification in their credit rating system that allowed companies to have a higher credit rating for their debt than the credit rating of said country. Previous to this alteration in their system, Country A could be downgraded from Aaa to Aa1 and in turn no company based in Country A could have a rating above Aa1. This led to an increase in debt and investment of upgraded firms versus downgraded firms (Tang (2009)). During the most recent examination into the balance sheets of European banks, it is found that banks more exposed to the sovereign shock tightened credit supply by more than those less exposed and that the European Central Banks attempt to alleviate the stress caused by the credit crunch with the Long-Term Refinancing Operation was not as successful as planned (De Marco (2013)).
3 Data
To examine the effect of sovereign debt downgrades on firm values, there were multiple data points that were needed to be used. Those included equity price returns during the given period before and after the downgrade date, and the returns of the main stock index in each country. In addition to this, the sovereign debt ratings for the countries being examined are also necessary along with the dates when those were downgraded.
In addition, we also use the history of sovereign credit ratings, credit outlooks
and watches on various countries denominated debt from Standard and Poor’s. As the timing of ratings announcements are irregular, we focus on the monthly or yearly impact of ratings announcements on realized return measures aggregated from the daily frequencies.
Table 1. Rating Symbols for Long-Term Debt
The table below translates the long-term debt ratings for Moody’s to Standard and Poor’s and also a brief interpretation of each rating level.
Interpretation Moody's Standand and Poor's
Investment-Grade Ratings
Highest quality Aaa AAA
Aa1 AA+ Aa2 AA Aa3 AA- A1 A+ A2 A A3 A-Baa1 BBB+ Baa2 BBB Baa3 BBB-Speculative-Grade Ratings Ba1 BB+ Ba2 BB Ba3 BB-B1 B+ B2 B B3 B-High-risk obligations Adequate payment capacity High quality Strong payment capacity Likely to fulfill obligations, ongoing uncertainty
Table 2. Number of Observations
The table below presents the sample of sovereign credit rating downgrades, and the number of treated observations (i.e., firm-year observations with pre-treatment rating at the sovereign bound) using S&P long-term foreign currency issuer ratings.
Sovereign Rating
Downgrade Before After Number of
Country Year Downgrade Downgrade Observations
Argentina 2001 BB- DDD 4
2008 B+ B- 3
2012 B B- 1
Brazil 2002 BB- B+ 5
France 2012 AAA AA+ 3
Indonesia 1997 BBB BB+ 1 1998 BB+ CCC+ 5 Ireland 2011 A BBB+ 4 Italy 2004 AA AA- 1 2006 AA- A+ 2 2011 A+ A 2 2012 A BBB+ 2 Japan 2001 AAA AA 1 2002 AA AA- 4 2011 AA AA- 13 Mexico 2009 BBB+ BBB 4 Philippines 2005 BB BB- 2 Portugal 2010 A+ A- 1 2011 A- BBB- 2 Spain 2012 AA- BBB- 2 Thailand 1997 A BBB 1 1998 BBB BBB- 2
United States 2011 AAA AA+ 4
3.1 Selection of Countries and Indices
For the selection of countries, we focused on the countries that had been downgraded by Standard and Poor’s Rating Agency and that had stock indices.
3.2 Equity Price Returns
Equity price returns denotes a formula normally used by shareholders and investors who invest in a firm’s equity which allows them to see how much return they can obtain from their equity investment. It is a good measure of a company’s financial stability and profitability as it measures profits made by investing shareholders’ funds.
Return on equity is calculated by:
Markets clearly work faster and more accurately than ratings firms to assess a country's financial condition and evaluate the potential impacts on its cost of capital and equity market. That is why most firms never solely rely upon credit ratings and pay attention to how the market perceives particular bonds.4
4 Also shown that the sovereign ceiling policy is associated with ratings that tend to be more pessimistic for treated firms relative to control firms
Table 3. Statistical Data by Country
This table reports the average values of daily realized return, realized volatility, skewness, and kurtosis for stock markets in each of the 75 sample countries from Jan 1996 to May 2010.
15
Country Return Volatility Skewness Kurtosis
Argentina 0.00008 0.00028 -0.18561 0 Australia 0.00007 0.01452 -0.12898 0.46346 Austria 0.00002 0.05183 -0.16014 4.56037 Bahrain 0 0.00007 0.01575 0 Belgium 0.00022 0.00295 -0.04395 0.01503 Botswana 0.00067 0.00042 -0.00211 0 Brazil -0.0001 0.00206 -0.08711 0.00879 Bulgaria 0 0.0041 -0.08985 0.0186 Canada 0.00017 0.00003 -0.13428 0 Chile 0.00013 0.00257 -0.1526 0.0101 China 0.00085 0.00323 -0.02761 0.01201 Columbia 0.00071 0.00018 -0.1471 0 Costa Rica 0.00003 0.00038 -0.13453 0 Croatia -0.00045 0.03768 -0.10326 0.90303 Cyprus 0.00032 0.00016 -0.22606 0 Czech Rep 0.00013 0.00095 -0.12572 0.00045 Denmark -0.00005 0.0021 -0.25855 0.00269 Ecuador -0.0106 0.0582 0.0176 0.28241 Egypt -0.00283 0.16023 -0.14593 4.30264 Estonia 0 0.00022 -0.16591 0 Finland 0 0.00024 -0.19368 0 Germany 0.00005 0.00096 -0.10564 0.00097 Ghana 0.00179 0.00021 -0.03711 0 Greece 0.00009 0.00189 -0.06776 0.00459 Hong Kong -0.00125 0.00621 -0.16033 0.12316 Hungary 0.00017 0.01451 -0.14959 0.29332 Iceland -0.00003 0.00024 -0.1713 0 India 0.00008 0.0161 -0.16509 0.0933 Indonesia 0.00004 0.00024 -0.12889 0 Ireland 0.00011 0.04736 -0.16267 2.91451 Israel -0.00002 0.00015 -0.08888 0 Italy -0.00006 0.00033 0.00253 0 Japan 0.00006 0.00019 -0.06995 0 Jordan -0.00019 0.0002 0.15047 0 Kazakhstan -0.00006 0.00012 0.03581 0 Korea 0.00002 0.00028 -0.08062 0
Country Return Volatility Skewness Kurtosis Lebanon -0.000514 0.0108 0.00179 0.08757 Lithuania -0.00005 0.0002 -0.00224 0 Luxembourg 0 0.00012 -0.18167 0 Malaysia -0.00043 0.10803 -0.01492 2.73877 Malta 0.00239 0.0099 -0.15741 0.15068 Morocco 0.00023 0.00214 -0.10692 0.00337 Netherlands -0.00002 0.0004 -0.14181 0.00011 New Zealand 0 0.00006 -0.10811 0 Nigeria 0.00036 0.03026 -0.37644 0.80129 Norway 0.00001 0.00009 -0.07928 0 Oman 0.00039 0.00103 0.12028 0.00083 Pakistan 0.00008 0.00026 -0.11896 0 Peru 0 0.00262 -0.18121 0.0062 Philippines 0.0008 0.11763 -0.00289 10.85617 Poland 0.00073 0.06885 0.03734 5.0154 Portugal 0.00004 0.00327 -0.13439 0.01206 Qatar -0.0002 0.00042 -0.13648 0 Romania 0.0001 0.00033 -0.02801 0 Russia 0.00013 0.00047 -0.20863 0 Saudi Arabia 0.00006 0.00017 -0.15152 0 Serbia 0.00053 0.00124 0.1835 0.00037 Singapore -0.00002 0.00021 -0.09078 0 Slovakia 0.00011 0.06096 -0.25398 2.08371 Slovenia -0.00004 0.00022 -0.26883 0 South Africa -0.00004 0.00026 -0.06358 0 Spain 0.00006 0.00035 -0.13738 0.00002 Sri Lanka -0.00003 0.01503 -0.108649 0.29305 Sweden -0.0001 0.00026 0.05281 0 Switzerland 0.00007 0.00026 -0.11883 0 Taiwan 0.00001 0.00028 -0.11821 0 Thailand -0.00004 0.00067 0.10587 0.00044 Turkey 0.00035 0.0007 -0.05842 0.00028 Ukraine -0.00069 0.00259 -0.06568 0.00386 U.K. 0 0.00012 -0.09557 0 Uruguay 0 0.00024 -0.07336 0
Figure 1. Real and Nominal Returns by Country
The figure below shows the annualized equity return for different countries in both nominal and real terms. To make clear comparisons across markets, it is meaningful therefore to focus on real returns. The countries in the figure have therefore been ranked by their annualized real returns, with the worst performers on the left and the best on the right. The Figure shows that six of the worst performers in terms of real returns on the left-hand side experienced some of the highest nominal returns across all countries.
Standard and Poor’s Rating Services has a database of the sovereign debt ratings for any country that is followed by them. Through the use of this database, downgrade dates were discovered of the previously selected countries found in Table 4. This data set was also confirmed by using the Bloomberg Professional Service on the Bloomberg Terminal.
4 Methodology | Empirical Analysis
This thesis will use the event-study method in order to estimate abnormal returns from the effect of rating announcements. Abnormal Returns are the crucial measures used to assess the impact of an event. The general idea of this measure is to isolate the effect of the event from other general market movements. The abnormal return of firm is an event date, which in this case is defined as the difference of the realized return and the expected return given the absence of the event.
I will pull stock returns and plot them with the announcement dates. The announcement dates will be time 0 and the abnormal returns will be plotted before and after. Also, the share of international sales will be compared to the market that the firm deems as home. Risk adjusted abnormal market returns on a daily basis will be derived from the market model:
ARit = Rit – (αi + βiRmt) Where Ritis the return of the firm
Rmtis the market return
The expected return is unconditional on the event but conditional on a separate information set. Dependent on the definition of the information set (e.g., past asset returns) and the functional form there exist various models for the normal return.
The market model uses a data selection of 250 days before the rating downgrade and the abnormal returns are calculated firm by firm. After that is done, a weighted average is made by using their firm’s market capitalization and the firm’s abnormal return.
5 Results and Findings
5.1 US Only
The 2011 S&P downgrade was the first time the United States was given a rating below AAA which affected immediately after Standards and Poor’s had announced a negative outlook on the AAA rating in April 2011 to AA+. The credit rating assigned to the United States is an expression of how likely the US is likely to refund its debts, and influences interest rates the US will have to pay on its debts. It should be noted that these ratings sometimes take account of different prospects; for instance, Moody Credit Rating Agency considers the expected value of the debt in the event of a default in addition to the probably of default. Some lenders also have contractual requirements only to hold debt above a certain credit rating.
Government agencies such as the Accountability Office, the Congressional Budget Office, the Office of Management and Budget and the U.S. Treasury Department all reported that the federal government is facing financing challenges as shown below in Figure 2.
Figure 2. Debt as a Percentage of GDP
This figure is an excerpt from the United States Congressional Budget Office (CBO) June 2011 report depicting how public debt will move as a percentage of Gross Domestic Product (GDP). The “Extended-Baseline Scenario” assumes the tax cuts implemented by the Bush presidential administration will expire in 2012 among other cost savings including Medicare, Medicaid and government spending would come to the lowest level since World War II. The “Alternative Fiscal Scenario” expects the opposite.
Tax revenues have declined significantly due to severe recession and tax-policy choices, while expenditures have expanded for wars, 5unemployment insurance and other safety net
spending. In the long-run, expenditures related to healthcare programs such as Medicare and Medicaid are growing considerably faster than the economy overall as the population matures.
Standards & Poor’s considered the government budget deficit of more than 11 percent of gross domestic product (GDP), and net government debt rising to about 80 percent or more of GDP by 2013, to be high relative to other AAA rated countries. According to S&P,
meaningful progress towards balancing the budget would be required to move the U.S. back to a ‘stable’ outlook.
Market consequences
Global stock markets declined on August 8, 2011, following the announcements on degrade. All three major U.S. stock indexes declined between five and seven percent in one day. However, U.S. treasury bonds, which had been the subject of the downgrade, actually rose in price and the dollar gained in value against the Euro and the British pound as seen in Figure 3, indicating a general flight to safe assets amid concerns about a European debt crisis.
Based on historical information from Bloomberg, the cost to insure U.S. debts against default has risen from an average of approximately 25 basis points to a range from 55 to 75 basis points in 2011. A higher cost of insurance is typically associated with increased risk of default.
Figure 3. US Dollar value versus Euro and British Pound
S&P was direct in its criticism of the governance and policy-making process, which took the U.S. to the brink of default as part of the 2011 U.S. debt-ceiling crisis that same week:
"More broadly, the downgrade reflects our view that the effectiveness, stability, and
predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011. Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon."
"The political brinksmanship of recent months highlights what we see as America's
governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year's wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the
comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options.”
5.2 Non US
This table presents the base and full model panel estimation results for stock market realized return kurtosis over the sample from January 1996 to May 2010 for 75 countries. Model specifications are based on Crisis takes on a value of one during crisis periods and zero otherwise and the crises periods are from:
Jul. 1997 – Jan. 1998 for the Asian Financial Crisis (AFC) Aug. 1998 – Oct. 1998 for the Russian Debt Crisis (RDC)
Mar. 2000 – Sept. 2002 for the Tech/Terrorist (Tech) crisis of confidence Jul. 2007 – May 2010 for the Global Financial Crisis (GFC)
Dec. 2008 – May 2010 for the European Debt crisis (EDC).
ALL is an aggregate indicator of these major crises including the brief Brazilian (in Feb. 1999) and Turkish (Feb. 2001) crises. *, ** and *** denote significance at the 10, 5 and 1% levels (t-statistics are shown in parentheses).
As the table above shows, it is apparent that the short-term debt has a significant influence on distance. On the other hand, the researve growth growth influences the drift fact. However, it is interestingly to note that the the drift factor is consistently negative, pointing a move a way from the crisis threshold within a particular time. Furthuremore, when a poisson model and a probit model are correlated against each other, the threshold model appears to be better than either of these alternatives. It is also apparent that overvaluation, inflation and researve losses determines the level of vulnerability. Furthuremore, a significant level of dynamics, researve detoriation, past rate of exchanges and volatilty predict future vulnerability.
Alternative Choices for Crisis Dummy
Variable ALL AFC GFC RDC TECH EDC
D(RATING) -0.0000 (-1.35) - -0.0000 (-1.26) - -0.0000 (-1.39) - -0.0000 (-1.23) - -0.0000 (-1.23) - -0.0000 (-1.28) - D(OUTLOOK) -0.0000 (-0.61) - -0.0000 (-0.49) - -0.0000 (-0.42) - -0.0000 (-0.46) - -0.0000 (-0.78) - -0.0000 (-0.52) - RATING -0.78 -0.79 -0.73 -0.78 -0.81 -0.79 - -0.0000 (-1.01) 9.8021 19.556 (3.04)*** (5.30)*** D(CCRATING) -0.5398 (-0.17) - -0.76661 (-0.27) - -0.5775 (-0.19) - -0.8071 (-0.28) - -0.4486 (-0.15) - -0.8795 (-0.31) - Crisis*D(CCRATING) -0.9437 (-0.12) - 0.2585 (0.00) - -4.3218 (-0.44) - -6.6836 (-0.20) - -1.3508 (-0.11) - 0.7114 (0.01) - -2.7526 - -2.8333 - -2.6631 - -2.7738 - -2.4143 - -2.7797 - (4.16)*** (4.26)*** (-3.97)*** (-4.19)*** (-3.65)*** (-4.20) *** RKURTt-1 0.0000 (1.24) -0.0121 (-0.62) 0.0000 (1.22) -0.0106 (-0.55) 0.0000 (1.21) -0.0103 (-0.53) 0.0000 (1.22) -0.0101 (-0.52) 0.0000 (1.25) -0.0175 (-0.90) 0.0000 (1.22) -0.0101 (-0.52) 1.1648 - 1.1802 - 1.0731 - 1.1455 - 0.9938 - 1.1494 - (4.31)*** (4.32)*** (3.88)*** (4.24)*** (3.68)*** (4.24)*** Oil 0.0216 (0.93) - 0.0164 (0.71) - 0.0106 (0.45) - 0.0162 (0.70) - 0.0172 (0.75) - 0.0143 (0.62) - -56.0512 - -50.6049 - -43.6969 - -49.1077 - -44.6809 - -49.3546 - (-4.30)*** (-3.91)*** (-3.20)*** (-3.83)*** (-3.49)*** (-3.83)*** -FXReG 0.2807 (0.36) - 0.0972 (0.11) - -0.1480 (-0.18) - 0.0839 (0.11) - -0.6661 (-0.84) - 0.1018 (0.13) - -0.0093 - -0.0094 - -0.0091 - -0.009 - -0.0106 - -0.009 - (-2.34)** (-2.28)** (-2.29)** (-2.29)** (-2.67)*** (-2.29)** 0.0000 (-3.63)*** 0.0000 (3.01)*** -0.71 (-6.35)*** GDP Developing COMPRISK CCRATING -4.2956 (-1.09) -0.0000 (-0.74) -4.1586 (-0.38) -0.0000 (-0.97) 0.0000 (0.09) 8.2421 (0.38) - 0.0000 (0.96) - 0.0000 (0.64) - Crisis 0.0000 (0.31) -8.9518 (-1.08) 0.0000 (0.66) - 0.0000 (1.06) - - Crisis*D(OUTLOOK) - 0.0000 (0.77) - -0.0000 (-0.11) - Crisis*D(RATING) 0.0000 (1.53) - 0.0000 (2.75)*** - 0.0000 (1.9)* -
5.3 Combined
As a result of sovereign downgrades on firms, firms that have ratings equal to those with high credit quality in the country had to cut their investments by 25%, decrease long term leverage by 15% and observe their bond yields increase by 34 basis points. The trends of sovereign bond spreads can be seen in the figures 4 and 5, bond spreads increase during negative announcements and decrease during positive announcements. The findings were due to several factors which hindered the firm’s ability to access bonds and commercial markets papers such as determination on whether investors would be allowed to invest in firms’ securities using credit ratings, ratings affected banks and insurance companies’ credit
requirements, rating downgrades triggered bond covenant violations, increased bond coupons and loan interest rates forcing bond repurchases. With regards to spreads for sovereign debt by ratings, see Figure 6 for December 2010. Downgrades directly impacted on business operations such as the ability of firms and countries to enter long term supply or financial contracts. Governments thus need to be aware of the unintended effects of sovereign credit downgrades the private sectors and which exacerbate consequence of public debt crisis on real economic activities.
Figure 4: Mean of Relative Spreads during Negative Announcements
This figures plots mean of relative bond spreads before during and after negative
Figure 5: Mean of Relative Spreads during Positive Announcements
This figures plots mean of relative bond spreads before during and after positive
announcements. The mean of relative spreads is calculated by (Yield – Treasury) / Treasury.
Negative Announcements | Mean of Relative Spreads
Days relative to announcement 0.27 0.28 0.29 0.30 0.31 0.32 0.33 -30 -25 -20 -15 -10 -5 0 5 10 15 20
Negative Announcements | Mean of Relative Spreads
Days relative to announcement 0.31 0.32 0.33 0.34 0.35 0.36 0.37 0.38 ‐30 ‐25 ‐20 ‐15 ‐10 ‐5 0 5 10 15 20
Figure 6: Sovereign Bond Spreads by Credit Rating
6 Conclusion
In essence, the lower credit rating of the US by the Standards and Poor’s agencies in 2011 may be attributed to various economic and socio-political factors. According to Metzler (2011), the year 2011 was marked by dire economic realities and global events. These events included but not limited to sudden social change and US military triumphs alongside the intense political activities. In a showdown stirred by the midterm election which made the Republicans occupies the House of Representatives in an endeavor to foil Barack Obama’s presidency. This saw occasional wrangling by lawmakers over whether or not to raise the ceiling on the federal debt. Despite the fact that both the Democrats and Republicans agreed on the necessity of doing this, Republicans had more interest in securing more spending concession from Democrats so that they can be able to accomplish some of the promises they had made from the campaign in order to leverage on the country’s fiscal order. However, there was no consensus on some of the key issues and this difficulty in reaching a
compromise resulted into the bond rating agency to downgrade the US credit rating.
Sovereign Bond Spreads by Credit Rating as of Decmeber 2010
Aaa/AAA Aa2/AA A2/A Baa2/BB Ba2/BB B2/B
0 1 2 3 4 5 6% Fitted sovereign spreads Average corporate spreads
In line with the S&P analysis, we also attest the assumption that the poor governance and policy-making process of the federal government at time largely contributed debt-ceiling crisis experienced at that time. It is agreeable that policies and the effectiveness of
governance affect the economic and social conditions of where people thrive alongside the quality of life and the decision of firms on whether or not to invest. Furthermore, the
economic institutions, business firms and companies which are very significant in driving the economies are subject to public policy (Acemoglu and Robinson, 2012). In addition, tax decisions and policy by the government, business leaders and voters affect income inequality, job growth, income, GDP, savings and income inequality. Therefore, it is quite in order to state that the low and particularly poor credit performance in the US was largely influenced by the government’s poor governance and bad policies.
In line with the findings of this study, many companies on a global level cut down their investment by a significant margin from 1996 to May 2010. Indeed, this may be attributed to financial and economic downturn experienced by countries or regions in various periods. For instance the Asian Financial Crisis greatly affected growth of companies in Asia, some of which were forced to close down. Similarly the Russian Debt Crisis, European Debt crisis and in more general terms the Global Financial Crisis in Jul. 2007 – May 2010 affected local, regional, and multinational companies. Majority of these companies were performing dismally, and thus this may explain why they were being rated lowly by the respective rating firm S&P. It is also agreeable that many businesses will not be able to sustain themselves in volatile economic times and those which can do so may not be able to make reasonable profits. This will subsequently deprive the firms the ability to invest, qualify for credit or pay back debts. This may work to explain the low credit rating of firms in this study.
This paper offers evidence showing categorically that credit ratings affect firm investment and financial policy using sovereign rating downgrades as a natural experiment. Sovereign
downgrades create exogenous and asymmetric variation across firm ratings because of rating agencies’ ceiling policy that prevents firms from having ratings above the sovereign rating. Firms with ratings at the sovereign bond cut investment and leverage more than otherwise similar firms with rating below the control group following a sovereign downgrade. We can also deduce that sovereign credit ratings receive considerable attention in financial markets and the press. We find that the ordering of risks is widely consistent with
macroeconomic fundamentals.
Furthermore, the bond yields of treated firms increase more than those of control firms, which is consistent with an increase in the firm’s cost of borrowing and reduction in capital supply due to sovereign-related downgrade. One important feature of our identification strategy is that higher-quality firms are more affected than lower-quality firms, which rules out several alternative explanations of the results.
Changes in sovereign credit ratings have a more significant impact on realized measures than outlook revisions. We find clear evidence that rating events have significant impacts on the first four moments of stock market returns during both normal market conditions and in times of financial crises. However, it is notable that our evidence shows financial crises do not serve to increase the sensitivity of realized stock return distributions to different types of ratings information nor heighten financial market instability.
These results show that ratings have causal effects on firm policies, which are not confounded by variation in unobservable firm characteristics or macroeconomic conditions. Second, we identify unintended consequence for real economic activity of sovereign ceiling policies that are typically followed by rating agencies. We establish that public debt management can have important real consequences for a country’s economy through the sovereign ceilings channel.
References
Abadie, Alberto, David Drukker, Jane Leber Herr, and Guido W. Imbens, 2004,
Implementing matching estimators for average treatment effects in stata, Stata Journal 4, 290-311.
Abadie, Alberto, and Guido W. Imbens, 2011, Bias-corrected matching estimators for average treatment effects, Journal of Business & Economic Statistics 29, 1-11.
Alesina, Alberto, Sule Ӧzler, Nouriel Roubini, Phillip Swagel, 1992, Political Instability and Economic Growth
Almeida, Heitor, Igor Cunha, Miguel A. Ferreira, Felipe Restrepo, 2013, The Real Effects of Credit Ratings: Using Sovereign Downgrades as a Natural Experiment
Baum, Christopher F, Margarita Karpava, Dorothea Schafer, and Andreas Stephan, 2014, Credit Rating Agency Downgrades and the Eurozone Sovereign Debt Crises
Boot, Arnoud W. A., Todd T. Milbourn, and Anjolein Schmeits, 2006, Credit ratings as coordination mechanisms, Review of Financial Studies 19, 81-118.
Borensztein, Eduardo, Kevin Cowan, and Patricio Valenzuela, 2013, Sovereign ceilings lite? The impact of sovereign ratings on corporate ratings, Discussion paper.
Brooks, Robin, and Marco Del Negro, 2003, Firm-Level Evidence on International Stock Market Comovement.
Brooks, Robert, Robert William Faff, David Hillier, and Joseph Hillier, 2004, The national market impact of sovereign rating changes, Journal of Banking & Finance 28, 233-250.
Chernenko, Sergey, and Adi Sunderam, 2012, The real consequences of market segmentation,
Review of Financial Studies 25, 2041-2069.
Congress of the United States, Congressional Budget Office. CBO’s 2011 Long-Term Budget
Outlook. June 2011. www.cbo.gov
De, Indrani, 2013, Understanding the S&P 500; This Index Offers a lot of International Exposure, The Journal of Investment Consulting 14.
De Marco, Filippo, 2013, Bank Lending and the Sovereign Debt Crisis, Discussion paper.
Faulkender, Michael, and Mitchell A. Petersen, 2006, Does the source of capital affect capital structure?, Review of Financial Studies 19, 45-79.
Ferreira, Miguel A., and Paulo M. Gama, 2007, Does sovereign debt ratings news spill over to international stock markets?, Journal of Banking & Finance 31, 3162-3182.
Gande, Amar, and David C. Parsley, 2005, News spillovers in the sovereign debt market,
Journal of Financial Economics 75, 691-734.
Graham, John R., and Campbell R. Harvey, 2001, The theory and practice of corporate finance: evidence from the field, Journal of Financial Economics 60, 187-243.
Harford, Jarrad, and Vahap Uysal, 2013, Bond market access and investment, Journal of
Financial Economics forthcoming.
Heckman, James, Hidehiko Ichimura, Jeffrey Smith, and Petra Todd, 1998, Characterizing selection bias using experimental data, Econometrica66, 1017-1098.
Holmstrom, Bengt, and Jean Tirole, 1997, Financial intermediation, loanable funds, and the real sector, The Quarterly Journal of Economics 112, 663-91.
Kisgen, Darren J., 2006, Credit ratings and capital structure, Journal of Finance 61, 1035- 1072.
Kisgen, Darren J., 2007, The influence of credit ratings on corporate capital structure decisions, Journal of Applied Corporate Finance 19, 65-73.
Kisgen, Darren J., 2009, Do firms target credit ratings or leverage levels?, Journal of
Financial and Quantitative Analysis 44, 1323-1344.
Kisgen, Darren J., and Philip E. Strahan, 2010, Do regulations based on credit ratings affect a firm's cost of capital?, Review of Financial Studies 23, 4324-4347.
Kräussl, R., (2005), Do credit rating agencies add to the dynamics of emerging market crises?,
Journal of Financial Stability 1(3), 355–385.
Journal of Finance 60, 2575-2619.
Lemmon, Michael, and Michael R. Roberts, 2010, The response of corporate financing and investment to changes in the supply of credit, Journal of Financial and Quantitative Analysis 45, 555-587.
Lemmon, Michael L., Michael R. Roberts, and Jaime F. Zender, 2008, Back to the beginning: Persistence and the cross-section of corporate capital structure, Journal of Finance 63, 1575-1608.
Ӧzler, Sule, and Guido Tabellini, 1991, External debt and political instability.
Roberts, Michael, and Toni Whited, 2010, Endogeneity in empirical corporate finance,
Handbook of the Economics of Finance 2.
Sufi, Amir, 2009, The real effects of debt certification: Evidence from the introduction of bank loan ratings, Review of Financial Studies 22, 1659-1691.
Tang, Tony T., 2009, Information asymmetry and firms' credit market access: Evidence from moody's credit rating format refinement, Journal of Financial Economics 93, 325-351.
