Credit Rating Agencies' Function on Bond Markets: Price Stability vs. Information Transmission

Abstract

The relation that may exist between rating announcements and bond spreads is unclear, despite the fact that many event studies have been dedicated to that problem. Several of them cast a doubt upon the utility and the function of credit rating agencies on the bond markets, which are usually supposed to transmit information about issuer default risks. This paper aims to re-examine the function of credit rating agencies on the bond markets. The first part of the paper presents the model while the second part is dedicated to an empirical study, relying on a new methodology, and covering the rating actions of Moody's in the euro zone during these last ten years.

The theoretical model re-examines the function of the rating agencies in an oligopolistic environment, considering the existence of informed and not informed investors on the market, taking into account the different strategies of the agencies to acquire or maintain their credibility, to optimize their investigation effort, and their communication relative to the rating revisions. In the empirical part of the paper, a new methodology, relying on unit root tests, especially Perron (1997), rather than classical methodologies relying on the CARs, is implemented. It allows the split of the rating events between two main categories: the non informative and the informative events, characterized by a significant and long-lasting change in the relative spread surrounding the period of the rating change, which is denoted by a structural break in the series. Thus, the main hypotheses expressed in the theoretical model may be validated by the empirical analysis; this confirms the different functions of the agency, and a role depending on the market segment where the agency operates.

Keywords: rating agency, event study, bond market, information and market efficiency, unit root test

JEL Classification: G14, G24