Agency Costs and Investor Response to Municipal Bond Ratings

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