Have Rating Agencies Become More Conservative? Implications for Capital Structure and Debt Pricing

We show that rating agencies have become more conservative in assigning credit ratings to corporations over the period 1985 to 2009. Holding firm characteristics constant, average ratings have dropped by three notches (e.g., from A to BBB ) over time. Consistent with the view that this change has not been fully warranted, we find that defaults for both investment grade and non-investment grade firms have declined over time. The increased stringency has also affected capital structure, cash holdings, growth, and debt spreads. Firms that suffer more from this conservatism issue less debt, have lower leverage, and hold more cash; they are also less likely to obtain a debt rating and they experience lower sales growth. However, their debt spreads are lower compared to the spreads of firms with the same rating that have not suffered from this conservatism, which implies that the market partly undoes the impact of conservatism on debt prices. This evidence suggests that firms and capital markets do not perceive the increase in conservatism to be fully warranted