Compensation Incentives of Credit Rating Agencies and Predictability of Changes in Bond Ratings and Financial Strength Ratings

by Andreas Milidonis of University of Cyprus

September 26, 2012

Abstract: Prior studies attribute the lead effect of investor-paid over issuer-paid credit rating agencies to the heterogeneity in their compensation structure and incentives. We investigate the lead-lag relationship between investor- and issuer-paid rating agencies’ bond ratings (BRs) and financial strength ratings (FSRs) for the US insurance industry. First, we find that changes in issuer-paid BRs are led by changes in investor-paid BRs, even in a period of heavy criticism towards issuer-paid rating agencies. Second, information flows in both directions between changes in issuer-paid BRs and FSRs. Third, issuer-paid FSRs are predictable by investor-paid BRs. Fourth, the lead effect of investor-paid downgrades is economically significant as it is associated with an unconditional, post-event, thirty-day cumulative abnormal return of -4%. This return is a result of investor-paid downgrades in BRs, which predict more downgrades in the following ninety days (same period return of -11%).

JEL Classification: G14, G22, G24.

Keywords: credit rating agencies, information dissemination, timeliness, predictability, insurance.

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