What’s in a Debt? Rating Agency Methodologies and Firms’ Financing and Investment Decisions

Abstract In July 2013, Moody’s unexpectedly increased the amount of equity credit speculative-grade firms receive for preferred stock from 50% to 100%. Firms affected by the rule change were suddenly considered less levered by Moody’s, even though their balance sheets did not change. These firms responded by issuing debt to restore the original leverage ratio as defined by Moody’s and growing their assets. The rule change transferred value from debt to equity holders and led to an increase in preferred stock issuance. How rating agencies assess risk thus has a significant causal impact on firms’ financing, investment, and security design decisions. (JEL G24, G32)