Unexpected Bond Ratings and the Cost of Municipal Debt

Abstract

We investigate whether credit rating agencies (CRAs) and investors price the extent to which municipal bond ratings are explainable using public information. We use an ordinal logistic regression to estimate the expected and unexpected portions of bond ratings, and find that both CRA fees and yield premiums are higher for negative unexplained (i.e., pessimistic) ratings. CRA fees are not generally associated with positive unexplained (i.e., optimistic) ratings, although we document a positive association when financial reporting quality or investor sophistication is low. While creditors price both pessimistic and optimistic unexplained ratings, yield premiums for pessimistic ratings are significantly greater than yield discounts for optimistic ratings. These findings manifest after the passage of the Dodd-Frank Act, among sophisticated investors, and among municipalities with high financial reporting quality. We contribute to research that examines the determinants of municipal debt costs, CRA fees, and the information content of bond ratings.

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

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