The impact of sovereign credit ratings on Eurobond yields: Evidence from Africa

The importance of sovereign credit ratings and Eurobonds issued by governments have come to the fore in Africa in the last decade. We examine whether changes in sovereign credit ratings impact Eurobond yields in 8 countries over the period of 2014–2019. Our approach reviews rating changes impact on Eurobond yields utilising the event study methodology. Our findings reflect that, on average, close to a third of rating actions directly impact bond yields in African countries. The statistically significant events include the downgrades of South Africa and Namibia to non-investment grade in 2017 reflecting critical transitions and bond investors’ reactions. Overall, the low percentage of a third, relative to previous international studies, suggests that largely rating changes are anticipated, do not have much new information and perhaps the perceived power of credit rating agencies may be overstated. In our view, the results reflect that pre-announcements of rating review dates since 2014 makes rating actions predictable and less impactful to bond yields. In addition, they reflect that bond investors adjust in real time as new information come in, resulting in less reliance on the opinions of CRAs and using their own assessments.     

Firstborn CEOs and credit ratings

Our study examines whether CEOs’ birth order can predict firms’ credit ratings. Consistent with studies that document a positive relationship in the general population between being firstborn and being conservative, our study finds that firms managed by firstborn CEOs tend to have higher credit ratings than those managed by later-born CEOs. Our results are robust to controlling for additional personal CEO traits, such as political identity, and to using a propensity score matching sample. A change analysis supports the causality of the firstborn effect. We suggest that return on assets and free cash flow are possible channels through which firstborn status affects credit ratings. Cross-sectional analyses show that the positive association is less (more) pronounced for firstborn CEOs who have a pilot license (run firms in less competitive industries). These results suggest that managerial conservatism may be an important factor in credit rating agencies’ credit risk assessments.     

Sovereign credit ratings and bank funding cost: Evidence from Africa

This paper aims to examine the relationship between sovereign credit ratings and funding costs of banks and also the relationship between sovereign credit ratings. Using over 300 banks operating in Africa from 2006 to 2012, the study investigates sovereign ratings’ impact on funding cost. The long term domestic sovereign ratings announced by Fitch and Standard & Poor’s during the period under study were used. The panel made use of Generalized Method of Moments estimation strategy for funding cost. The findings of the study indicate that sovereign ratings upgrades have an inverse and statistically significant relationship with funding costs. The findings suggest that sovereign rating upgrades makes it easier for banks to access funds from the capital and global market at a cheaper cost compared to rating downgrades. The study recommends and encourages emerging economies to use the services provided by credit rating agencies since these agencies may help improve accessibility of funds in the international markets by banks. It is recommended that sovereign rating should be considered as a supplement and not a substitute to our own perceived judgement and research.     

Bankruptcy probability changes and the differential informativeness of bond upgrades and downgrades

Prior studies have found that stock returns around announcements of bond upgrades are insignificant, but that stock prices respond negatively to announcements of bond downgrades. This asymmetric stock market reaction suggests either that bond downgrades are timelier than upgrades, or that voluntary disclosures by managers preempt upgrades but not downgrades. This study investigates these conjectures by examining changes in firms’ probabilities of bankruptcy (assessed using bankruptcy prediction models) and voluntary disclosure activity around rating change announcements. The results indicate that the assessed probability of bankruptcy decreases before bond upgrades, but not after. By contrast, the assessed probability of bankruptcy increases both before and after bond downgrades. We also find that controlling for potential wealth-transfer related rating actions, which can impact stock returns differently, does not alter our results. Tests of press releases and earnings forecasts issued by firms suggest that the differential informativeness of upgrades and downgrades is not caused by differences in pre-rating change voluntary disclosures by upgraded and downgraded firms. The results support the hypothesis that downgrades are timelier than upgrades.     

Exploring the components of credit risk in credit default swaps

In this paper, we test the influence of various fundamental variables on the pricing of credit default swaps. The theoretical determinants that are important for pricing credit default swaps include the risk-free rate, industry sector, credit rating, and liquidity factors. We suggest a linear regression model containing these different variables, especially focusing on liquidity factors. Unlike bond spreads which have been shown to be inversely related to liquidity (i.e., the greater the liquidity, the lower the spread), there is no a priori reason that the credit default swap spread should exhibit the same relationship. This is due to the economic characteristics of a credit default swap compared to a bond. Our empirical result shows that all the fundamental variables investigated have a significant effect on the credit default swap spread. Moreover, our findings suggest that credit default swaps that trade with greater liquidity have a wider credit default swap spread.     

The (un)informative value of credit rating announcements in small markets

This work examines the information value of local Israeli credit rating announcements. This matter is also important to other small markets, in which a debt issuer may take advantage of a “rating shopping” process or choose to avoid a rating procedure altogether, because the agencies do not carry out unsolicited rating. We analyze the bond and equity markets response to various rating announcements at different time periods. We find that except for downgrades in 2008–2009 the rating announcements have no information value. It seems that generally the market internalizes most of the information prior to the rating announcements.     

Selecting credit rating models: a cross-validation-based comparison of discriminatory power

In commercial banking, various statistical models for corporate credit rating have been theoretically promoted and applied to bank-specific credit portfolios. In this paper, we empirically compare and test the performance of a wide range of parametric and nonparametric credit rating model approaches in a statistically coherent way, based on a ‘real-world’ data set. We repetitively (k times) split a large sample of industrial firms’ default data into disjoint training and validation subsamples. For all model types, we estimate k out-of-sample discriminatory power measures, allowing us to compare the models coherently. We observe that more complex and nonparametric approaches, such as random forest, neural networks, and generalized additive models, perform best in-sample. However, comparing k out-of-sample cross-validation results, these models overfit and lose some of their predictive power. Rather than improving discriminatory power, we perceive their major contribution to be their usefulness as diagnostic tools for the selection of rating factors and the development of simpler, parametric models.

The relationship between liquidity risk and credit risk in banks

This paper investigates the relationship between the two major sources of bank default risk: liquidity risk and credit risk. We use a sample of virtually all US commercial banks during the period 1998–2010 to analyze the relationship between these two risk sources on the bank institutional-level and how this relationship influences banks’ probabilities of default (PD). Our results show that both risk categories do not have an economically meaningful reciprocal contemporaneous or time-lagged relationship. However, they do influence banks’ probability of default. This effect is twofold: whereas both risks separately increase the PD, the influence of their interaction depends on the overall level of bank risk and can either aggravate or mitigate default risk. These results provide new insights into the understanding of bank risk and serve as an underpinning for recent regulatory efforts aimed at strengthening banks (joint) risk management of liquidity and credit risks.     

Assessing the credit risk of money market funds during the eurozone crisis

This paper measures credit risk in prime money market funds (MMFs) and studies how such credit risk evolved during the eurozone crisis of 2011–2012. To accomplish this, we estimate the annualized expected loss on each fund's portfolio. We also calculate by Monte Carlo the cost of insuring a fund against losses amounting to over 50 basis points. We find that credit risk of prime MMFs, though small, doubled from 12 basis points in June 2011 to 23 basis points in December 2011 before receding in 2012. Contrary to common perceptions, this did not primarily reflect funds’ credit exposure to eurozone banks because funds took measures to reduce this exposure. Instead, credit risk in prime MMFs rose because of the deteriorating credit outlook of banks in the Asia/Pacific region. We conclude that the increase in the credit risk of prime MMFs in the second half of 2011 reflected contagion in the worldwide banking system coupled with slowing global economic growth, not actions taken by MMFs.     

Sovereign risk assessment and agency credit ratings

Sovereign ratings are gaining importance as more governments with greater default risk borrow in international bond markets. However, while the ratings have proved useful to governments seeking market access, the difficulty of assessing sovereign risk has led to agency disagreements and public controversy over specific rating assignments. Recognising this difficulty, the financial markets have shown some scepticism toward sovereign ratings when pricing issues.     

Bank-firm relationship and credit risk: An analysis on Tunisian firms

This paper analyses the impact of the intensity and length of bank-firm lending relationship on Tunisian banks’ credit risk over the period 2001–2012. The sample includes 494 bank-firm relationships for 383 firms. By applying probit and ordered probit models, our results indicate that firms which engage in intense relationships with banks are less likely to encounter a credit default. In addition, these firms exhibit a higher loan quality. However, no evidence has been found for the impact of the relationship length on credit risk. Further, the findings show that private banks, unlike public financial institutions, take advantage of their close lending relationships with borrowers to mitigate information asymmetry and therefore improve their loans portfolio quality.     

Contagion effect on bond portfolio risk measures in a hybrid credit risk model

This paper illustrates how modelling the contagion effect among assets of a given bond portfolio changes the risk perception associated to it. This empirical work is developed in a hybrid credit risk framework that incorporates recovery rate risk. Dependence structures among firms and between external shocks affecting firms together are considered. The presence of correlations among firm leverage ratios and the interrelation between default probabilities and recovery rates produces clusters of defaults with low recovery rates. This has a major impact on standard risk measures such as Value-at-Risk and conditional tail expectation. Consequently, an appropriate measurement of the contagion has a tremendous effect on the capital requirement of many financial institutions.     

Modeling the business risk of financially weakened firms: A new approach for corporate bond pricing

Most structural models of default risk assume that the firm's asset return is normally distributed, with a constant volatility. By contrast, this article details the properties that the process of assets should have in the case of financially weakened firms. It points out that jump-diffusion processes with time-varying volatility provide a refined and accurate perspective on the business risk dimension of default risk. Representative Arrow-Debreu state price densities (SPD) and term structures of credit spreads are then explored. The credit curves show that the business uncertainties play a major in the pricing of corporate liabilities.     

Credit ratings and IPO pricing

We examine the effects of credit ratings on IPO pricing. The evidence from U.S. common share IPOs during 1986–2004 shows that when firms go public, those with credit ratings are underpriced significantly less than firms without credit ratings. Credit rating levels, however, do not have a significant effect on IPO underpricing. The existence of credit rating reduces uncertainty about firm value. It is the value certainty that matters, not the value per se. Credit ratings also reduce the degree of price revision during the bookbuilding process and the aftermarket volatility in the post-IPO period. The evidence suggests that credit ratings convey useful information in reducing value uncertainty of the issuing firms as well as information asymmetry in the IPO markets.     

Credit ratings and the cross-section of stock returns

Low credit risk firms realize higher returns than high credit risk firms. This is puzzling because investors seem to pay a premium for bearing credit risk. The credit risk effect manifests itself due to the poor performance of low-rated stocks (which account for 4.2% of total market capitalization) during periods of financial distress. Around rating downgrades, low-rated firms experience considerable negative returns amid strong institutional selling, whereas returns do not differ across credit risk groups in stable or improving credit conditions. The evidence for the credit risk effect points towards mispricing generated by retail investors and sustained by illiquidity and short sell constraints.     

Counterparty credit risk and the credit default swap market

Counterparty credit risk has become one of the highest-profile risks facing participants in the financial markets. Despite this, relatively little is known about how counterparty credit risk is actually priced. We examine this issue using an extensive proprietary data set of contemporaneous CDS transaction prices and quotes by 14 different CDS dealers selling credit protection on the same underlying firm. This unique cross-sectional data set allows us to identify directly how dealers' credit risk affects the prices of these controversial credit derivatives. We find that counterparty credit risk is priced in the CDS market. The magnitude of the effect, however, is vanishingly small and is consistent with a market structure in which participants require collateralization of swap liabilities by counterparties.     

Confucian culture and corporate bond pricing

We investigate the effect of Confucian culture on corporate bond pricing. Using the birthplace data of 56,759 Jinshi in the Ming and Qing dynasties to construct a proxy of Confucian culture, we find a significantly negative relation between Confucian culture and bond pricing: the stronger the Confucian atmosphere of the corporate headquarters’ location, the higher the bond rating and the lower the credit spread. This conclusion still holds after using the distance to the nearest ancient printing office as an instrumental variable and a series of robustness tests. The mechanism test shows that Confucian culture can improve the pricing efficiency of corporate bonds by fostering investors’ trust, alleviating principal–agent problems and restraining bad corporate behaviors. Moreover, the impact of Confucian culture on corporate bond pricing is greater for firms located in regions with weak legal and other formal institutional constraints and for unlisted companies. Our study complements the literature on culture and bond pricing, and provides policy insights from traditional Chinese wisdom for improving the efficiency of financial markets.     

Robust and consistent estimation of generators in credit risk

Bond rating Transition Probability Matrices (TPMs) are built over a one-year time-frame and for many practical purposes, like the assessment of risk in portfolios or the computation of banking Capital Requirements (e.g. the new IFRS 9 regulation), one needs to compute the TPM and probabilities of default over a smaller time interval. In the context of continuous time Markov chains (CTMC) several deterministic and statistical algorithms have been proposed to estimate the generator matrix. We focus on the Expectation-Maximization (EM) algorithm by Bladt and Sorensen. [J. R. Stat. Soc. Ser. B (Stat. Method.), 2005, 67, 395–410] for a CTMC with an absorbing state for such estimation. This work’s contribution is threefold. Firstly, we provide directly computable closed form expressions for quantities appearing in the EM algorithm and associated information matrix, allowing to easy approximation of confidence intervals. Previously, these quantities had to be estimated numerically and considerable computational speedups have been gained. Secondly, we prove convergence to a single set of parameters under very weak conditions (for the TPM problem). Finally, we provide a numerical benchmark of our results against other known algorithms, in particular, on several problems related to credit risk. The EM algorithm we propose, padded with the new formulas (and error criteria), outperforms other known algorithms in several metrics, in particular, with much less overestimation of probabilities of default in higher ratings than other statistical algorithms.     

Information risk and credit contagion

This paper demonstrates a positive relationship between information risk and the credit contagion effect. We use abnormal changes in the Credit Default Swaps (CDS) spreads to measure the contagion effect, and the dispersion of analyst forecasts as a proxy for information risk. We find that firms with higher information risk suffer a greater contagion effect that occurs in advance to the credit default events. This finding is robust under controls of key firm-specific characteristics and general condition of stock and credit markets.     

A Multicriteria Approach for Modeling Small Enterprise Credit Rating: Evidence from China

ABSTRACT

As the engine of China’s economy, small enterprises have been the central to the country’s economic development. However, given the characteristics of the small enterprises loan (i.e., short borrowing period, large volume, small amount and incomplete information), it is extremely challenging for financial institutions to assess their creditworthiness. Thus, it seriously delays and restricts the financing access for small enterprises. In an attempt to relieve the financing difficulty of small enterprises, this article makes use of 687 small wholesale and retail enterprises in a regional commercial bank in China, to establish a credit rating indicator system composed of 17 indicators by using both partial correlation analysis and probit regression. It then utilizes TOPSIS together with fuzzy C-means to score the credit ratings of our sample of small enterprises. With the dual test of default discrimination and ROC curve, the prediction accuracy of the established indicator system has reached 80.10% and 0.917, respectively, indicating the robustness and validity of our credit rating system.