Compensation Incentives of Credit Rating Agencies and Predictability of Changes in Bond Ratings and Financial Strength Ratings

Abstract

Over the past decade there has been mixed evidence on the lead-lag relation between issuer-paid and investor-paid credit rating agencies. We investigate the lead-lag relationship for changes in bond ratings (BRs) and financial strength ratings (FSRs), for the US insurance industry, where FSRs impose market discipline. First, we find that changes in issuer-paid BRs are led by changes in investor-paid BRs, even over a period that issuer-paid agencies have improved their timeliness. Second, information flows in both directions between changes in issuer-paid BRs and FSRs. Third, issuer-paid FSRs are predictable by investor-paid BRs. Fourth, the lead effect of investor-paid downgrades is economically significant as it is associated with an unconditional, post-event, thirty-day cumulative abnormal return of -4%. This return is a result of investor-paid downgrades in BRs, which predict more downgrades in the following ninety days (same period return of -11%).

Keywords: credit rating agencies, information dissemination, timeliness, predictability, insurance

JEL Classification: G14, G22, G24