Credit rating agencies are widely viewed as neutral observers of corporate risk, translating complex financial statements into familiar letter grades that tell investors how likely a company is to repay its debts. New research from the McCombs School of Business at The University of Texas at Austin suggests that these ratings can do far more than describe a company’s financial condition. They can change it. By altering the way a particular security was treated on corporate balance sheets, Moody’s effectively made some already-risky companies appear safer overnight. Those companies then borrowed more, invested more and saw their stock prices rise, even though their underlying businesses had not immediately changed.
The study, conducted by Cesare Fracassi, associate professor of finance at UT Austin, and Gregory Weitzner of McGill University, examines how rating-agency methodology can influence corporate decisions. Their findings indicate that companies do not simply accept ratings as passive judgments. Instead, managers may respond strategically when a change in methodology improves their apparent creditworthiness. The researchers found that affected firms borrowed an average of 22% more after Moody’s revised its treatment of preferred stock. Much of the additional financing was directed toward assets, equipment and other investments, revealing how a technical accounting classification can produce real economic consequences.
The mechanism behind the shift lies in leverage, a core measure used by credit analysts to assess default risk. Leverage generally compares a company’s debt with its equity or total capital. A heavily debt-funded company has greater fixed obligations and is therefore more vulnerable if revenues fall or interest costs rise. Rating agencies use leverage ratios alongside profitability, liquidity, cash flow and other indicators to determine whether a borrower deserves an investment-grade rating or belongs in the riskier, below-investment-grade category. Even a change that does not affect a company’s operations can alter these ratios, potentially giving executives more room to issue debt without triggering a downgrade.
Preferred stock occupies precisely this kind of accounting gray zone. Like bonds, preferred shares typically promise investors a fixed dividend, making them resemble debt with a predetermined payment. Yet preferred stock is legally and financially different from conventional borrowing. A company generally does not have to repay the original investment on a fixed maturity date, and skipping a preferred dividend does not normally constitute a default in the same way as missing an interest payment on a bond. Preferred shares therefore combine characteristics of debt and equity, creating a classification problem for analysts who are trying to estimate how much financial pressure a company truly carries.
Before July 2013, Moody’s treated preferred stock issued by below-investment-grade companies as partly debt and partly equity. Half of its value counted as debt, while the other half counted as equity. The approach reflected the security’s hybrid nature: preferred stock could impose regular financial expectations on a company, but it did not create the same contractual repayment obligation as a bond. Moody’s then changed the methodology for companies already rated below investment grade, classifying their preferred stock as 100% equity. Nothing about the firms’ factories, revenues, employees, cash flows or legal obligations changed. But their reported credit profiles did.
Fracassi and Weitzner used the policy change as a natural experiment. Among 475 companies rated below investment grade, 44 held preferred stock on their balance sheets and were directly affected by the reclassification. The remaining companies provided a comparison group that did not receive the same mechanical improvement in their Moody’s leverage calculation. This design allowed the researchers to distinguish the effect of the rating methodology from broader economic movements affecting all speculative-grade businesses. For the companies with preferred stock, average leverage fell from 61.9% to 57.1% in the agency’s assessment, an improvement roughly equivalent to moving up one rating notch.
That apparent improvement created additional borrowing capacity. Because more of the companies’ capital was now treated as equity, their debt burden looked smaller relative to their total capitalization. The firms responded by increasing overall leverage by an average of 3.1 percentage points during the remainder of 2013. In other words, they used at least part of the newly available financial room to take on debt, bringing their leverage back upward. Across the affected group, the researchers estimate that companies borrowed substantially more than comparable firms, supporting the conclusion that the ratings change did not merely alter investor perceptions; it influenced managerial financing choices.
The extra borrowing also appeared to support expansion. Compared with similar companies that were not affected by the reclassification, the firms with preferred stock increased their assets and equipment by approximately 8%. Their stock prices rose by about 2.8% over the same period, suggesting that equity investors viewed the increased financing and investment as potentially valuable. The results are consistent with a company using a stronger-looking rating position to fund growth, acquisitions, capital projects or other initiatives. At the same time, the strategy increased exposure for lenders and bondholders, because the companies ultimately carried more debt than they otherwise might have.
The findings do not establish that Moody’s decision was universally harmful or beneficial. From shareholders’ perspective, borrowing to finance productive investment can increase the value of a company, particularly when managers identify opportunities that generate returns above the cost of capital. For debt holders, however, the same decision can increase default risk by adding obligations that must be serviced in the future. The research therefore highlights a central tension in credit markets: a rating methodology can influence how managers allocate capital, while the resulting corporate actions may create risks that were not visible in the original numerical improvement.
The study also carries a broader warning for investors who treat credit ratings as complete measures of financial health. Rating agencies faced intense criticism after the 2008 financial crisis for failing to capture risks embedded in complex securities, including investments linked to subprime mortgages. The new research points to a different vulnerability: even when a rating is calculated according to a disclosed methodology, a classification rule can become a behavioral force. Investors may therefore need to examine the composition of a company’s capital structure, the assumptions behind its leverage ratios and the way hybrid securities are treated. A letter grade can summarize risk, but it can also reshape the incentives that determine how much risk a company takes.
Subject of Research: The influence of credit-rating methodologies on corporate borrowing, leverage and investment decisions.
Article Title: What’s in a Debt? Rating Agency Methodologies and Firms’ Financing and Investment Decisions
Web References: https://www.mccombs.utexas.edu/faculty-and-research/faculty-directory/profile/?username=cf8745; https://doi.org/10.1093/rcfs/cfag026
References: Fracassi, Cesare, and Gregory Weitzner. “What’s in a Debt? Rating Agency Methodologies and Firms’ Financing and Investment Decisions.” The Review of Corporate Finance Studies. DOI: 10.1093/rcfs/cfag026.
Keywords: credit rating agencies, Moody’s, preferred stock, corporate debt, leverage, corporate finance, investment decisions, financial risk, capital structure, speculative-grade companies
