Agency Costs and Investor Response to Municipal Bond Ratings

56 Pages Posted: 14 Sep 2020 Last revised: 31 Jul 2023

See all articles by Amanda Beck

Amanda Beck

Georgia State University

Linda M. Parsons

University of Alabama - Culverhouse School of Accountancy

Trevor Sorensen

University of Wyoming - Department of Accounting

Date Written: September 14, 2022

Abstract

We investigate whether investors incorporate potential agency costs, which increase with issuers’ incentives to obtain inflated ratings, when pricing municipal bonds. To do so, we exploit unique aspects of the setting that are previously unexplored in the context of municipal bond ratings: the extent to which ratings are not correlated with publicly available financial and economic data, the presence of heightened political incentives, and low financial reporting quality. Consistent with expectations, we find that investors discount ratings under these conditions. Despite accusations of upwardly biasing bond ratings, additional analyses fail to provide consistent evidence of widespread rating inflation. We find some evidence of a fee premium for optimistic ratings, but the premium dissipates when there is a strong mayor and when financial reporting quality is high. Taken together, results suggest that issuers’ costs for obtaining an optimistic rating and/or having lower financial reporting quality are twofold: these issuers pay more for bond ratings which, in turn, are discounted by investors. These findings are relevant to municipal investors and regulators, as well as researchers concerned with the cost of information asymmetry in the municipal bond market.

Keywords: municipal bonds, bond ratings, credit rating agencies, credit rating fees

JEL Classification: G12, G24, G28, D82, H74, M40, M41

Suggested Citation

Beck, Amanda and Parsons, Linda M. and Sorensen, Trevor, Agency Costs and Investor Response to Municipal Bond Ratings (September 14, 2022). Available at SSRN: https://ssrn.com/abstract=3664916 or http://dx.doi.org/10.2139/ssrn.3664916

Amanda Beck (Contact Author)

Georgia State University ( email )

P.O. Box 4050
Atlanta, GA 30302-4050
United States

Linda M. Parsons

University of Alabama - Culverhouse School of Accountancy ( email )

101 Paul W. Bryant Dr.
Box 870382
Tuscaloosa, AL 35487
United States

Trevor Sorensen

University of Wyoming - Department of Accounting ( email )

Laramie, WY 82070
United States

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