A study reveals how rating agencies weigh governance factors.
Recent research relates the importance of corporate governance not to stockholders but rather to another important stakeholder: bondholders. Ever since spectacular failures occurred at previously well-regarded companies, the spotlight has shone on corporate governance activities as the means of preventing fraud and aligning management with shareholders’ interests. After all, in the spate of bankruptcies that began with Enron Corp. in 2001, shareholders were left with billion-dollar losses in market capitalization in a short period of time.
Bondholders suffered as well. In 2002, Worldcom Inc. famously went from having a coveted investment-grade long-term credit rating to bankruptcy in less than three months. It stands to reason that if better corporate governance would prevent such fraud as has been alleged at Worldcom, then credit rating agencies, notably Standard & Poor’s (S&P), Moody’s Investor Service and Fitch, the three organizations approved by the U.S. government, would factor those variables into credit ratings.
“The Effects of Corporate Governance on Firms’ Credit Ratings,” a working paper under review at the Journal of Accounting & Economics, confirms the link between governance and credit ratings. In fact, the paper states that “a hypothetical firm that possesses desirable governance characteristics from the bondholders’ viewpoint nearly doubles its likelihood of receiving an investment-grade rating.” That should get boards to take notice.
The study reveals how perceptions of corporate governance practices by the capital markets affect the company’s cost of capital. Credit ratings are judgments on the risk of default. As such, if a company has a higher credit rating, it is deemed more likely to make its debt payments and generally pays a lower interest rate on the bonds it issues.
A key characteristic is whether a company’s debt receives a rating high enough to be considered “investment grade,” or whether it has to pay the higher interest rates associated with speculative bonds (such as high-yield or junk bonds). Because some investors are barred from holding speculative securities, the spread is large between investment-grade and speculative bond yields. Thus, if corporate governance affects the ability of a company to maintain an investment-grade credit rating, it could impact a company’s cost of capital.
How great would the impact be? “The median firm in our sample had $934 million of outstanding debt,” says co-author Daniel W. Collins, the Henry B. Tippie Research Chair in Accounting at the University of Iowa’s Henry B. Tippie College of Business.