Determinants and Consequences of Unexpected Bond Ratings: Evidence from Municipal Bond Rating Fees and Yield Premiums

Abstract

Municipal bond investors consider bond ratings assigned by credit rating agencies (CRAs) when making investment decisions. Investors also evaluate other public information about the issuer, which may indicate a different level of creditworthiness than the rating suggests. We examine the information content of unexpected bond ratings using determinants (CRA fees) and consequences (yield premiums). Regarding determinants, we find a positive association between fees and the magnitude of unexpected ratings, especially when ratings are lower than expected (pessimistic) or when more work is required to rate the bond. We find no evidence that political incentives lead to higher-than-expected (optimistic) ratings. Regarding consequences, we find that investors respond asymmetrically to unexpected ratings. Specifically, the penalties for pessimistic ratings exceed the discounts for optimistic ratings. Our evidence suggests that unexpected ratings are informative to investors. Further, municipalities pay more, both to CRAs and as interest, when ratings are lower than expected.

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

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