On the surface, credit rating agencies assess a company’s financial health by examining its debt, equity, and ability to meet financial obligations. They assign letter grades that indicate the likelihood that a company will repay its debts. However, new research suggests that rating agencies may do more than evaluate financial risk. Their assessments can also influence how companies make financing and investment decisions.

Cesare Fracassi, associate professor of finance at the McCombs School of Business at The University of Texas at Austin, and Gregory Weitzner of McGill University examined how a change in Moody’s rating methodology affected corporate behaviour. They found that when Moody’s reclassified certain securities on companies’ balance sheets, affected firms subsequently borrowed an average of 22% more, even though their underlying financial circumstances had not changed.

A key factor in credit ratings is leverage, or the ratio of debt to equity. Generally, higher debt relative to equity indicates greater financial risk because a company has more obligations to repay. Yet not every financial security fits neatly into the categories of debt or equity. Some securities have characteristics of both, creating a grey area in determining a company’s leverage.

One example is preferred equity, also known as preferred stock. Like a bond, preferred stock generally pays a fixed dividend, making it resemble debt. Unlike conventional debt, however, it does not necessarily have to be repaid, and failure to pay a dividend does not automatically trigger default. Because of this hybrid nature, rating agencies traditionally treated preferred stock as 50% debt and 50% equity.

In July 2013, Moody’s changed its methodology for companies rated below investment grade, which were already considered relatively risky. Instead of treating preferred stock as half debt and half equity, Moody’s began classifying it as 100% equity. The accounting fundamentals and business operations of these companies had not changed, but the new classification made their financial positions appear stronger from a credit-rating perspective.

The researchers studied 475 companies rated below investment grade, including 44 that held preferred stock. Following Moody’s change, the affected companies appeared safer because their average leverage declined from 61.9% to 57.1%. According to the researchers, this reduction was comparable to receiving a one-notch improvement in a credit rating and effectively gave the companies additional capacity to borrow.

The companies took advantage of that capacity. During the remainder of 2013, affected firms increased their overall leverage by an average of 3.1 percentage points compared with other companies. They also increased assets and equipment by approximately 8%, suggesting that much of the additional financing supported business investment and growth. Their stock prices also rose by approximately 2.8%.

The findings demonstrate how credit ratings can shape corporate financing strategies even when a company’s underlying financial condition has not materially changed. Although increased borrowing and investment may benefit shareholders, additional debt can create greater risks for creditors. For investors, the research highlights the importance of looking beyond a company’s credit rating and examining its underlying financial position, financing choices, and risk exposure before making investment decisions.

More information: Cesare Fracassi et al, What’s in a Debt? Rating Agency Methodologies and Firms’ Financing and Investment Decisions, The Review of Corporate Finance Studies. DOI: 10.1093/rcfs/cfag026

Journal information: The Review of Corporate Finance Studies Provided by University of Texas at Austin