The role of restrictive covenants in Moody's and standard and Poor's debenture credit ratings
ISSN: 0307-4358
Article publication date: 22 June 2023
Issue publication date: 8 November 2023
Abstract
Purpose
To determine the effect that covenants have on the credit ratings assigned by the two major agencies.
Design/methodology/approach
The authors examine 1,822 bond issues from 1991 to 2018, with a two-stage methodology to account for the endogeneity of the firms' choices and the ordinal nature of the ratings. The authors use Hendry's model selection method to find the best-fitting models from 37 control variables; the final models feature 20–24 orthogonalized variables, all significant at 5% and most at 1%.
Findings
The study’s results suggest that restrictive covenants positively affect ratings, particularly for bonds on the border of junk and investment grade. However, this effect appears to be decreasing with time, suggesting the financial crisis of 2008 has impacted ratings. Additionally, divergent covenant treatment leads to split ratings where the two agencies assign different levels of ratings on the same bonds. The study’s findings provide key insights into the factors that differentiate ratings given by each agency.
Practical implications
Managers must balance the perceived benefits of covenants against the costs, included lower credit ratings.
Originality/value
No other study has examined this issue controlling for both the ordinal nature of the ratings and the endogeneity in the decision to include specific covenants.
Keywords
Citation
Simpson, M. and Grossmann, A. (2023), "The role of restrictive covenants in Moody's and standard and Poor's debenture credit ratings", Managerial Finance, Vol. 49 No. 12, pp. 1899-1916. https://doi.org/10.1108/MF-07-2022-0304
Publisher
:Emerald Publishing Limited
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