Revisiting the time-varying credit rating policy: a new test of procyclicality

ABSTRACT

This article investigates whether agencies’ rating policy varies over macroeconomic cycle. We develop a novel two-stage estimation procedure to find that the rating policy becomes more strict after economic downturn than expansion, consistent with theoretical predictions. Moreover, from the horse race between various macroeconomic indicators, we find that the default spread serves as the strongest indicator for the time variation of rating standard.

KEYWORDS:

• Credit rating
• business cycle
• rating agency
• default spread

JEL CLASSIFICATION:

• G14
• G24

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ Standard & Poor’s (2008): Corporate Ratings Criteria, from www.standardandpoors.com.

² There are several papers that empirically examine the time variation of rating standard. For example, Becker and Milbourn (2011) study how competition among agencies (changed by the entry of Fitch) affects the rating standard; Blume, Lim, and Craig Mackinlay (1998), Alp (2013) and Baghai, Servaes, and Tamayo (2014) show that rating standards have tightened over time; Dilly and M¨ahlmann (2016) show that bonds issued in boom periods tend to be inflated; and deHaan (2017) finds that rating quality has improved after the recent global financial crisis.

³ The term spread is 10-year Treasury constant maturity minus 1-year Treasury constant maturity yields; the default spread is the difference between BAA and AAA corporate bond yields from the Federal Reserve; the stock market return is value-weighted return on all NYSE, AMEX and NASDAQ stocks minus the 1-month Treasury bill rate from the Kenneth French website; the volatility index is Chicago Board Options Exchange Volatility Index; and the growth rate of GDP is percentage change in the seasonally adjusted real GDP from the Bureau of Economic Analysis.