Electronic copy available at: http://ssrn.

com/abstract=1495849
Do Credit Rating Agencies Underestimate Liquidity Risk?

Radhakrishnan Gopalan

Fenghua Song

Vijay Yerramilli

February 8, 2009
Abstract
We test if credit ratings adequately reect liquidity risk, i.e., the risk that the rm may face di-
culty in renancing its short-term debt. Consistent with credit ratings underestimating liquidity
risk, we nd that after controlling for credit ratings and other known determinants, long-term
bonds of rms with a higher proportion of short-term debt trade at higher yields. Using multi-
notch downgrades to identify severe and unexpected rating downgrades, we nd that rms with a
higher proportion of short-term debt are more likely to experience multi-notch downgrades. The
association between short-term debt and multi-notch downgrades is stronger in industries that
experience a negative protability shock, during recessionary periods and when credit conditions
are tight. The relationship is robust to instrumenting the proportion of short-term debt. Overall,
our results highlight that rating agencies underestimate liquidity risk, and oer a potential ex-
planation for the failure of ratings to predict nancial diculties at rms such as Penn Central,
WorldCom, Enron, Bear Stearns and Lehman Brothers.

We thank Long Chen, Paolo Fulghieri, Wei Xiong, and seminar participants at Washington University in St. Louis
for helpful comments.

Olin Business School, Washington University in St. Louis. Campus Box 1133, 1 Brookings Drive, St. Louis, MO
63130. Email: gopalan@wustl.edu.

Smeal College of Business, Pennsylvania State University. University Park, PA 16802. Email: song@psu.edu.

Kelley School of Business, Indiana University. 1309 East Tenth Street, Bloomington, IN 47405. Email: vyer-
rami@indiana.edu.
Electronic copy available at: http://ssrn.com/abstract=1495849
Although we believe that our enhanced analytics will not have a material eect on the majority of our
current ratings, individual ratings may be revised. For example, a company with heavy debt maturities
over the near term (especially considering the current market conditions) would face more credit risk,
notwithstanding benign long-term prospects.
Standard and Poors Ratings Direct (May 13, 2008)
Introduction
Ratings issued by credit rating agencies such as Standard and Poors (S&P), Moodys and Fitch are
an important source of information for investors about the credit quality of corporate and government
bonds (Ederington et al. (1987), and Goh and Ederington (1993)). Over time, regulation has also
enhanced the role of rating agencies in nancial markets (White (2009)).
1
Given the increased
dependence of the nancial system on credit ratings, the failure of rating agencies to anticipate
distress at nancial institutions like Bear Stearns and Lehman Brothers, and defaults in mortgage-
backed securities during the recent nancial crisis has focussed the attention of both researchers and
regulators on the credit rating process.
Rating agencies have a long history of slow reaction to nancial distress at rated rms. For
example, over the years, they failed to warn investors about high-prole bankruptcies such as those
of WorldCom (2002), Enron (2001), First Executive Corporation (1991), and Penn Central (1970).
During the recent nancial crisis, all three major rating agencies were caught by surprise when Bear
Stearns announced on March 14, 2008 that it had obtained emergency funding from JPMorgan
Chase, and all three agencies continued to give a safe rating to Lehman Brothers right until the
day it led for bankruptcy.
2
Interestingly, a common thread running through all these high-prole
failures is the heavy reliance of the rm in question on short-term debt, which it was unable to roll
over. For instance, Penn Centrals bankruptcy was triggered by its reliance on commercial paper,
which it was unable to renance following heavy operating losses in 1970. A natural question that
1
An assets credit rating determines whether regulated institutions such as insurance companies and pension funds
can invest in it. The new Basel Capital Accord also prescribes that small and medium-sized credit institutions use
an assets credit rating to determine their risk weights for capital charges (Basel Committe on Banking Supervision
(1999)).
2
See Bear Stearns Has Credit Ratings Slashed After Bailout (Bloomberg News, March 14, 2008) and Flawed
Credit Ratings Reap Prots as Regulators Fail (Bloomberg News, April 29, 2009).
1
arises is whether credit rating agencies systematically underestimate the risk of rms not being able
to renance their short-term liabilities. Our paper addresses this question.
According to rating agencies, a rms credit rating provides their summary assessment of the
rms default likelihood. Such an assessment should take into account not only the risk of the rms
cash ows, but also the risk imposed by dierent aspects of the rms capital structure including
the maturity structure of its liabilities. Accounting for the maturity structure of liabilities is im-
portant because a rm that has to renance its liabilities more often is more likely to be exposed
to uctuations in credit market conditions, and is more likely to be aected by a temporary fall in
collateral values or cash ows.
3
Following Diamond (1991), we refer to the risk of a rm not being
able to renance its short-term liabilities as liquidity risk. Anecdotal evidence presented above
suggests that liquidity risk may be an important determinant of default risk, and hence, should be
incorporated in credit ratings.
We measure a rms exposure to liquidity risk using the variable Short, which we dene as the
proportion of the rms total debt that is maturing within the year. As a preamble to our analysis,
we rst examine whether investors in the secondary bond market recognize the presence of liquidity
risk and take it into account, over and above the rms credit rating, while pricing corporate bonds.
We follow Campbell and Taksler (2003) and model a bonds yield spread as a function of the issuing
rmss idiosyncratic volatility, market volatility, credit rating, rm nancial ratios including Short,
and macroeconomic variables. We nd that bonds issued by rms with higher values of Short have
higher yield spreads, even after controlling for the rms credit rating: a one-standard-deviation
increase in Short leads to a 5 basis point increase in the yield spread. This nding suggests that
bond investors price liquidity risk not captured by credit ratings.
4
Next, we formally address the question of whether rating agencies adequately account for liquid-
ity risk by analyzing a large panel of rated rms with nancial information in Compustat, spanning
the time period 19802008. In our empirical analysis, we use multi-notch rating downgrades (hence-
forth severe downgrades) to identify instances in which there is an unexpected decrease in the
rating agencys assessment of the rms overall credit quality. If rating agencies systematically un-
derestimate liquidity risk, then we should expect to observe a positive association between severe
3
CFOs surveyed in Graham and Harvey (2001) cite the cost of renancing in bad times as the second most
important factor aecting their choice of maturity structure of corporate debt.
4
This result is consistent with previous studies that show that bond markets reect credit risk information not fully
captured by ratings (Grier and Katz (1976), Hettenhouse and Sartoris (1976), and Pinches and Singleton (1978)).
2
downgrades and rms exposure to liquidity risk, as measured by Short. On the other hand, if rating
agencies correctly estimate liquidity risk when assigning ratings to rms, then we should not expect
any such systematic association. The underlying idea is that if there are two otherwise identical rms
that dier only in the maturity structure of their debt, then a rating agency that correctly estimates
liquidity risk will assign a lower rating ex ante to the rm with the higher proportion of short-term
debt, so that there should be no dierence ex post in terms of severity of rating downgrades.
Controlling for a variety of rm characteristics including the rms nancial condition, credit
rating, rm and year xed eects, we nd that rms with a higher proportion of short-term debt
are more likely to experience severe rating downgrades. This result is both statistically and econom-
ically signicant: a one-standard-deviation increase in Short is, on average, associated with a 2.1%
increase in the annual probability of a severe downgrade. In comparison, the sample average annual
probability of a severe rating downgrade is 4.4%. This positive association between Short and severe
rating downgrade is robust to controlling for recent negative outlooks issued by rating agencies and
the agencies desire to smooth rating changes around the investment-grade cuto. We also nd that
our results are present both for small and large rms, and for rms with investment-grade (S&P
rating of BBB- or above) as well as speculative-grade (S&P rating below BBB-) ratings.
To further establish that the positive association between severe rating downgrade and Short is
due to liquidity risk, we perform a number of cross-sectional tests. Firms with a larger proportion
of short-term debt are likely to face greater liquidity risk if they experience a negative shock to
their cash ows. Consistent with this idea, we nd that the positive association between Short and
severe downgrade is stronger for rms in industries that experience a decline in operating prots,
and during periods of economic recession. Consistent with the idea that liquidity risk is likely to be
more severe when credit market conditions are tighter, we nd that the positive association between
Short and severe downgrade is stronger when the spread between the prime interest rate charged by
banks and the federal funds rate is higher.
We recognize that the maturity structure of corporate debt is endogenous. Theory suggests
that high-risk and low-risk rms may pool together to issue more short-term debt as compared to
medium-risk rms (Diamond (1991)). Thus, an important alternative explanation for the positive
association between Short and severe downgrade is that rms which rely more on short-term debt
tend to be riskier, and hence, have more volatile credit ratings. Here, we must note that, based on
observable risk characteristics such as size, leverage and idiosyncratic volatility, rms in our sample
3
with higher values of Short are actually less risky. So we expect endogeneity to have a downward
bias on our coecient estimate on Short. Nonetheless, we perform three sets of tests to distinguish
our liquidity risk hypothesis from this alternative explanation.
First, if rms with a higher proportion of short-term debt are riskier rms that tend to have
more volatile credit ratings, then we should expect a positive association between Short and multi-
notch rating upgrades as well. By contrast, the liquidity risk hypothesis does not predict a positive
association between Short and multi-notch rating upgrades, because liquidity risk should only matter
on the downside. Consistent with the liquidity risk hypothesis, we do not nd a positive association
between Short and multi-notch rating upgrades.
In our second set of tests, we follow Almeida et al. (2009) and use the proportion of a rms long-
term debt maturing within the year as a measure of the rms exposure to liquidity risk, and repeat
our tests with this new measure. Note that this new measure excludes short-term debt securities
issued by the rm that mature within the year. The underlying idea is to identify rms exposed to
liquidity risk as a result of long-term debt maturity prole decisions made more than a year ago. Such
maturity decisions are less likely to depend on the rms current risk prole. Consistent with our
hypothesis that rating agencies underestimate liquidity risk, we nd a positive association between
the proportion of long-term debt maturing within a year and severe rating downgrades.
Finally, we employ instrumental variable (IV) regressions to control for any possible endogeneity
bias. Specically, we use the yield on the 10-year treasury bond, and the delta (i.e., sensitivity of
compensation to the rms share price) and vega (the sensitivity of compensation to the rms stock
return volatility) of the rms CFOs compensation to instrument for Short. The use of the 10-year
treasury yield as an instrument is motivated by the market-timing argument which suggests that rms
tend to borrow short term when long-term interest rates are high (Baker et al. (2003), Barclay and
Smith (1995), and Guedes and Opler (1996)). The use of delta and vega of the CFOs compensation
as instruments is motivated by Chava and Purnanandum (2009), who nd that the structure of
the CFOs compensation aects the rms debt maturity choice. Specically, they nd that CFOs
with higher delta choose signicantly less short-term debt, whereas CFOs with higher vega choose
signicantly more short-term debt. The identifying assumption is that the 10-year treasury rate
and the structure of the CFOs compensation package do not directly aect the severity of rating
downgrades, and only have an indirect eect through the rms debt maturity choice. This is a
reasonable assumption because the CFO of a rm mainly inuences the rms nancing policies, and
4
is likely to have less direct inuence on the rms investment policy and hence operational risk (see
Chava and Purnanandum (2009) for empirical evidence). We nd that our results continue to hold
even in our IV estimation. In fact, the coecient estimates in the IV estimation are signicantly
larger than our OLS estimates, which underscores our earlier observation that endogeneity has a
downward bias on our estimates.
While we use a rms reliance on short-term debt as a measure of its exposure to liquidity risk,
a rating downgrade may itself increase a rms exposure to liquidity risk by triggering covenants
that necessitate renancing, and also by making renancing more dicult (as happened in the case
of AIG). So it can be argued that the reason rating agencies resort to a multi-notch downgrade is
because they correctly factor in the increase in liquidity risk resulting from a rating downgrade. Note
that this explanation is not counter to ours, because if a rating downgrade increases liquidity risk
for rms with high Short, then rating agencies should anticipate such an eventuality and lower the
ex ante rating of such rms. At a minimum, our results indicate that ratings are more likely to be
subject to jumps downward for rms with a larger proportion of short-term debt. Moreover, we nd
that rms with a higher proportion of short-term debt also have a higher default likelihood even
after we control for lagged credit ratings. Since the default rating is assigned automatically when a
rm defaults on its debt obligations, and not at the discretion of the rating agency, this nding lends
further support to our hypothesis that rating agencies underestimate liquidity risk.
Our paper makes two important contributions. First, it contributes to the literature on credit
ratings by providing evidence that rating agencies systematically underestimate liquidity risk. It is
important to emphasize that our results are not about ratings of complex structured products, nor
are they conned to a specic time period when there may have been a credit bubble. We obtain
our results by examining corporate bond ratings over a long period of time spanning 28 years. In
comparison, recent papers have focused on ratings of structured products, the problems with the
issuer-pay model of credit ratings, and the structure of the rating agency (Benmelech and Dlugosz
(2009), Bolton et al. (2009), Skreta and Veldkamp (2009), White (2001), and White (2009)).
5
Our
paper contributes to this literature by highlighting an important dimension of risk not adequately
taken into account by rating agencies, and hence, an important reason behind the repeated failures
of rating agencies to anticipate nancial distress at rated rms.
5
It has also been suggested that credit rating agencies collude with banks to suppress adverse information about the
rms credit quality. See Enrons credit rating: Enrons bankers contacts with Moodys and government ocials,
2003 Report prepared by the Sta of the Committee on Governmental Aairs, United States Senate
5
Second, our paper contributes to the literature on debt structure and nancial contracting by
highlighting the liquidity risk associated with short-term debt. While theoretical literature identies
liquidity risk as an important determinant of debt maturity choice (Diamond (1991,1993), Flannery
(1986)), the empirical literature on debt maturity choice (Barclay and Smith (1995), Berger et al.
(2005), Guedes and Opler (1996), Stohs and Mauer (1994)) largely sidesteps this issue because of the
diculty of measuring liquidity risk. By looking at credit rating transitions, we are able to identify
whether an important intermediary adequately estimates liquidity risk. In this regard, our paper
is related to studies that exploit the current crisis to highlight liquidity risk inherent in short-term
debt. For example, Almeida et al. (2009) show that rms with a large proportion of their long-term
debt maturing right after August 2007 (when the subprime crisis unfolded) experienced large drops
in their real investment rates, and Duchin et al. (2009) nd that the decline in corporate investment
following the subprime crisis was more pronounced for rms that had more net short-term debt.
The paper proceeds as follows. In Section 1, we discuss the theoretical literature and outline
our hypotheses. Section 2 describes our data and empirical specication. Section 3 presents the
empirical results. Section 4 concludes.
1 Theory and Hypotheses
Diamond (1991) argues that short-term debt creates liquidity risk for the borrower because the
lender may refuse to roll over the debt if bad news arrives, forcing the rm into inecient liquidation
even when it is solvent in the long run. Such inecient liquidation may arise due to constraints
on pledging future rents to lenders because of agency costs or due to strategic uncertainty about
other lenders actions (Diamond and Dybvig (1983), and He and Xiong (2009)). Even if liquidation
is avoided, short-term debt can still cause loss of value if it has to be renanced at an overly high
interest rate because of credit market imperfections (Froot et al. (1993), Sharpe (1991), and Titman
(1992)). The upshot is that short-term debt can exacerbate the impact of temporary fall in the rms
cash ows, either by drying up the external sources of cash or increasing its cost. All these are going
to dilute the long-term creditors. Morris and Shin (2009) examine how the risk of a run on a rms
short-term debt undermines its long-term creditors and argue that the measure of an institutions
credit risk should incorporate the probability of a default due to a run [on its short-term debt] when
the institution would otherwise have been solvent. He and Xiong (2010) examine how short-term
6
debt exacerbates the conict of interests between a rms equity and debt holders and consequently
precipitates bankruptcy at higher fundamental thresholds. One basic takeaway from both Morris and
Shin (2009) and He and Xiong (2010) is that liquidity risk of short-term debt is an important source
of a rms overall credit risk. If rating agencies underestimate such liquidity risk while assigning
ratings to rms, we should observe more severe rating downgrades for rms that are more exposed
to liquidity risk, i.e., rms with a larger proportion of their debt maturing in the short term. On the
other hand, if rating agencies correctly estimate liquidity risk, then the severity of rating downgrade
should not be systematically related to the proportion of the rms debt maturing in the short term.
We refer to this as the liquidity-risk hypothesis.
It is important to recognize that the choice of debt maturity structure is endogenous and is
likely to be determined by rm characteristics such as rm size, growth opportunities (Myers (1977))
and information asymmetry (Diamond (1991,1993), Flannery (1986), and Kale and Noe (1990)).
The existing empirical literature documents that small rms, rms with more growth opportunities,
riskier rms, and rms with larger information asymmetry rely more on short-term debt (Barclay
and Smith (1995), Stohs and Mauer (1994), Titman and Wessels (1988)).
6
In our empirical tests,
we control for known determinants of debt maturity structure that may also aect the severity of
rating downgrade.
A positive association between the proportion of short-term debt and severe rating downgrade
may also result if riskier rms have both higher proportion of short-term debt (see Stohs and Mauer
(1994) for empirical evidence) and are also more likely to subject to severe rating downgrade. Rating
agencies are known to avoid frequent rating changes due to market participants desire for rating
stability (Altman and Rijken (2004), Fons et al. (2002), and Ellis (1998)). Such stickiness may
result in rating transitions only after signicant changes in credit quality. Since riskier rms are
more likely to experience signicant change in their credit quality, they may be especially prone to
severe rating transitions as compared to less risky rm. Apart from explicitly controlling for rm
risk based on observable characteristics, we also perform Dierence-in-Dierence estimations and
instrumental variable (IV) regressions to better distinguish the liquidity-risk hypothesis from this
alternate explanation.
6
Examining new bond issues, Guedes and Opler (1996) come to a somewhat dierent conclusion from Barclay and
Smith (1995) and Stohs and Mauer (1994). They nd that large rms with investment-grade credit ratings typically
borrow both at the short end and at the long end of the maturity spectrum, whereas rms with speculative-grade credit
ratings typically borrow in the middle of the maturity spectrum.
7
2 Data, Empirical Specications, and Preliminary Results
2.1 Data
Our data comes from three sources. We obtain data on monthly rm credit ratings from Standard and
Poors (S&P), which we complement with rm nancial information from Compustat. Our sample
consists of all rms with S&P long-term credit rating and nancial information in Compustat during
the period 1980-2008. We transform the rms credit rating into an ordinal scale ranging from 1 to
22, with 1 representing a rating of AAA and 22 representing a rating of D, i.e., a smaller numerical
value represents a higher rating (see Appendix for details). To align the monthly credit rating data
with annual rm nancial information, we drop years in which rms change the month they end
their scal year in.
We obtain data on long-term corporate bond yields from two modules of the Mergent Fixed
Income Securities Database (FISD). The rst module provides issue characteristics and the second
provides transaction prices for all bond trades among insurance companies from the National Asso-
ciation of Insurance Commissioners (NAIC) since 1995. Our sample selection criteria mirrors that of
Campbell and Taksler (2003). Specically, we focus on trades for investment-grade bonds, because
by regulation insurance companies often limit their investment to non-investment-grade bonds.
7
We
restrict our sample to xed-rate U.S. dollar-denominated bonds in the industrial, nancial and util-
ity sectors that are not defeased, defaulted or in default process. We exclude any bonds that are
callable, puttable, convertible, exchangable, with sinking fund or with refund protection. We also
exclude issues that are asset-backed or include credit-enhancement features to ensure that the bonds
are backed solely by the creditworthiness of the issuer. We estimate the yield to maturity for each
bond trade using the transaction price, time to maturity and coupon rate. We then calculate the
yield spread for a bond during a month as the dierence between the average yield to maturity on
all transactions for the bond during the month and the treasury yield on the government bond with
closest maturity. We obtain benchmark treasury yields from the Federal Reserve Board website.
Finally, we winsorize the data on yield spreads at the 1% level to reduce apparent data recording
error in FISD.
7
Also, as pointed out by Campbell and Taksler (2003), non-investment-grade bond trades in the FISD database are
unlikely to be representative of the general market.
8
2.2 Empirical Specications and Key Variables
We begin our empirical analysis by examining whether bond prices reect liquidity risk as measured
by the proportion of short-term debt. To achieve this, we estimate the regression model in Campbell
and Taksler (2003) after including Short as an additional regressor. Specically, we estimate the
following panel regression where each observation represents a bond-month pair:
Spread
b,
=
0
+
1
Short
i,t1
+
2
X
i,t1
+
3
X
b
+
4
X
m,
+ Rating FE + Firm FE + Year FE, (1)
where the subscripts b, i, m, and t indicate the bond, the rm, the market, the month and the
year, respectively, and the term FE denotes xed eect. The dependent variable Spread
b,
is the
average yield spread for a bond as measured from all the transactions for the bond during the
month. The main independent variable in our analysis is Short, the proportion of the rms debt
due within one year. We dene this as the ratio of total debt in current liabilities (Compustat item
dlc) to total debt (the sum of dlc and long-term debt dltt). We use the lagged values of Short
as the main independent variable to measure the extent of liquidity risk arising from short-term
liabilities. The rm characteristics that we employ as control variables include (X
i,t
) include: (i) the
mean and standard deviation of the rms daily excess return the dierence between the rms
stock return and the return on the CRSP value-weighted index over the 180 days proceeding
(not including) the bond trade, Average Excess Return and Equity Volatility respectively, (ii) the
ratio of the rms market capitalization to the market capitalization of the CRSP value-weighted
index, Market Cap/Index, (iii) the accounting ratios Long-Term Debt/TA (the ratio of total long-
term debt to the book value of total assets), Total Debt/Market Value (the ratio of total debt to
the sum of market value of equity and book value of total liabilities) and Operating Income/Sales
(the ratio of operating income before depreciation to net sales), and (iv) four dummy variables that
identify rms with Interest Coverage (the ratio of the sum of operating income after depreciation and
interest expense to interest expense) below 5, between 5 and 10, between 10 and 20 and above 20,
respectively. The bond characteristics (X
b
) that we control for are the bonds remaining maturity
in years, Maturity, the yield oered at the time of the bonds issue, Oering Yield, and the natural
logarithm of the dollar size of the issue, Log(Amount). We also control for market conditions (X
m,
),
including the mean and standard deviation of daily return on the CRSP value-weighted index over the
9
180 days prior to (not including) the bond transaction date, Average Index and Systematic Volatility
respectively, and the slope of the term structure which is the dierence between the 10-year and
2-year treasury rates, Treasury Slope.
We then examine the relationship between the proportion of short-term debt on a rms balance
sheet and the severity of rating downgrade of the rm. We do so by estimating panel regressions
that are variants of the following form where each rm-year combination represents one observation
in the panel:
y
i,t
=
0
+
1
Short
i,t1
+
2
X
i,t1
+ Industry or Firm FE + Year FE. (2)
The dependent variable y
i,t
measures the severity of rating downgrade for rm i in year t. We use
two alternate measures for severe rating downgrade. The rst measure, Notches Downgrade, is the
maximum number of notches by which a rms credit rating is downgraded during any month of the
year. The variable takes the value zero if the rms rating is not downgraded during the year. The
second measure, Multi-notch Downgrade, is a dummy variable that takes the value one for rms that
experience multi-notch downgrade at least once during a year. Thus, Multi-notch Downgrade equals
one if Notches Downgrade is greater than one.
8
We also control for a number of rm characteristics (X
i,t
) that may aect the likelihood of
rating downgrade. Following prior literature that identies a nonlinear relationship between rm
size and the amount of short-term debt and hence credit quality, we include a piecewise linear term
to control for rm size. Specically, we divide our sample into three terciles based on the book
value of total assets (TA) and include three interaction terms between the natural logarithm of book
value of total assets (Size) and dummy variables identifying rms belonging to these terciles. We
control for the rms credit quality with Investment Grade, a dummy variable that identies rms
with investment-grade ratings (BBB- or better) at the end of the previous year. We also control
for Long-Term Debt/TA, Total Debt/Market Value, Operating Income/Sales and Interest Coverage.
These accounting ratios have been shown in prior literature to aect rm credit ratings (Blume
et al. (1998), Pinches and Mingo (1973), and Pogue and Poldofsky (1969)). We control for rm
growth opportunities using Market-to-Book (the ratio of market value of total assets to book value
8
The following example illustrates how we construct the two measures. Suppose a rm starts with a rating of AA
in January. In March during the same year, its rating drops to AA- (1-notch downgrade), and in August the rating
continues to drop to A- (3-notche downgrade from March), and stays at A- until the end of the year. In this example,
Notches Downgrade = 3, and Multi-notch Downgrade = 1.
10
of total assets) and R&D/TA (the ratio of R&D to book value of total assets). We control for rms
operating risk using the annual cross-sectional operating income volatility of all rms in the industry,
Industry Volatility, and idiosyncratic volatility of the rms stock return, Idiosyncratic Volatility. We
control for the rms asset structure using the ratio of property, plant and equipment to total assets,
Tangibility, and the proportion of cash on the rms balance sheet, Cash/TA.
In our next set of tests, we use (2) to test whether the proportion of short-term debt aects
the likelihood of default. In these tests our dependent variable is Default, a dummy variable that
identies the year in which a rms long-term credit rating is downgraded to D.
2.3 Short-Term Debt and Yield Spreads on the Firms Long-Term Bonds
As a preamble to our analysis, we rst examine whether bond yield spreads are higher for rms with
a higher proportion of short-term debt on their balance sheets. We focus on bond returns because
liquidity risk is more likely to impose costs on bondholders.
In Panel A of Table 1, we divide the rms into two subsamples based on whether Short is above
or below the sample median and compare the yield spreads of bonds issued by the rms. We present
this comparison separately for the dierent sectors (nancial rms, utilities and industrial rms),
rating categories and maturity categories. We classify rms into three rating categories: High-
Rated rms (those with S&P rating {AAA, AA+, AA, AA-}), Medium-Rated rms (S&P rating
{A+, A, A-}), and Low-Rated rms (S&P rating {BBB+, BBB, BBB-}). Recall that we limit
bond transaction data only for investment-grade bonds. In terms of maturity categories, we classify
bonds as Short-Maturity bonds (maturity less than 7 years), Medium-Maturity bonds (maturity
between 7 and 15 years) and Long-Maturity bonds (maturity between 15 and 30 years). As can be
seen from Panel A, regardless of the sector, rating category or maturity category, bonds issued by
rms with above median proportion of short-term debt on average trade at higher yield spread as
compared to bonds issued by rms with below median proportion of short-term debt.
In Table 2, we perform multivariate tests by estimating (1). As mentioned, (1) is similar to the
model in Campbell and Taksler (2003) with Short as an additional regressor. The dependent variable
is the bond yield spread, which is the dierence between the average yield to maturity of all bond
transactions during a month and the yield on the treasury with the closest maturity. Recall that we
restrict attention to xed-rate U.S. dollar-denominated bonds without any special features (call and
11
put provisions, sinking fund, credit enhancements, etc.). Moreover, we limit our data to investment-
grade bonds. In Column (1) of Table 2, we estimate the regression on the bonds issued by all the
rms in our sample and include year and industry xed eects. We identify industry at the level of
the four-digit SIC code. The positive coecient on Short indicates that bonds issued by rms that
have a high proportion of their debt maturing in the short term trade at a higher yield, even after
controlling for the rms credit rating and all the other factors that are known to aect bond yields.
This nding is consistent with credit rating agencies systematically underestimating liquidity risk.
In Column (2), we repeat our estimation with rm xed eect instead of industry xed eect and
obtain similar results. Our results are economically signicant. The coecient estimates in Column
(2) indicate that a one-standard-deviation change in Short results in a 5 basis points change in the
bond yield spread. In comparison, the average bond yield spread in our sample is 113 basis points.
The coecients on the control variables are consistent with those in Campbell and Taksler (2003). In
particular, bond yield spreads are higher for rms with higher equity volatility, higher excess return
and during times of higher market volatility, and higher market return. Bond yield spreads are also
lower for large bond oerings, with lower maturity and for bonds of large rms.
In Columns (3) and (4), we repeat the regression separately on the subsamples of bonds issued
by small and large rms, respectively. The coecient on Short is signicant in Column (3) but not
in Column (4), indicating that the return premium we identied in Column (2) is conned to bonds
issued by small rms. In Columns (5) and (6), we repeat the regression separately on the subsamples
of high-rated bonds (i.e., bonds with credit rating {AAA, AA+, AA, AA-}) and low-rated bonds
(i.e., bonds with credit rating {BBB+, BBB, BBB-}). In both subsamples, we nd that bonds
issued by rms that rely more on short-term debt trade at higher yields.
Overall, the evidence in Table 2 indicates that, regardless of the bonds credit rating, bond market
investors seek a premium for taking on liquidity risk arising from short-term debt. This illudes that
the liquidity risk with short-term debt may not be adequately reected in credit ratings.
3 Empirical Results
We now look at rating downgrades to examine if rating agencies adequately account of liquidity risk
when they assign ratings to rms. Before we discuss the results of our multi-variate analysis, we rst
provide some summary statistics.
12
3.1 Short-Term Debt and Severity of Rating Downgrade
3.1.1 Summary Statistics and Univariate Tests
Descriptive statistics for the full sample are presented in Panel B of Table 1. The mean value of
Size of 8.015 in our sample corresponds to an average book value of total assets of approximately
$3 billion. The corresponding value for the full Compustat sample during the same time period is
$82 million. Thus, our sample of rated rms includes the larger rms in Compustat. Firms in our
sample have an average market-to-book ratio of 1.456 and spend about 1% of their total assets in
R&D. The median value of rm credit rating in our sample is 9 which corresponds to a rating of
BBB. Consistent with this, we nd that about 64% of the rms in our sample have investment-
grade ratings (BBB- or above). The likelihood for an average rm in our sample to experience a
rating downgrade within a year is 13%, and that likelihood is 4.4% for a multi-notch downgrade.
Multi-notch Downgrade (Conditional ) identies the instances when a rm experiences a multi-notch
rating downgrade conditional on a downgrade during the same year. The mean value of Multi-notch
Downgrade (Conditional ) indicates that about 32% of the downgrades in our sample are multi-notch
downgrades. From the mean value of Notches Downgrade (Conditional ), we nd that conditional
on a downgrade during a year, the notches downgraded is on average about 1.5. The mean value
of Short is 0.19, meaning that the average rm in our sample has 19% of its total debt maturing
within one year. Finally, the summary statistics of the other variables are consistent with our sample
comprising of the larger rms in Compustat.
In Panel C, we divide the rms into two subsamples with below and above sample median value
of Short and compare their characteristics. We nd that larger rms, rms with marginally lower
market-to-book ratios and better credit ratings are more likely to have above-median proportion of
short-term debt. We also nd that while rms with more short-term debt are no more likely to
experience a rating downgrade (the mean value of Downgrade is not signicantly dierent across the
two subsamples), such rms are more likely to experience multi-notch downgrade (the mean value of
Multi-notch Downgrade is signicantly dierent across the two subsamples). This is consistent with
the idea that rms with more short-term debt are more likely to be exposed to liquidity risk, which
is not adequately taken into account by rating agencies. We also nd that conditional on a rating
downgrade, such rms experience a more severe downgrade (the mean value of Notches Downgrade
(Conditional ) is signicantly dierent across the two subsamples).
13
Comparing the other nancial characteristics, we nd that rms with above-median value of
Short tend to be more protable, have a lower proportion of long-term debt to total assets, and have
a higher interest coverage. These rms are also from industries with lower volatility of operating
prots and tend to have lower idiosyncratic risk. All these indicate that these rms are less risky
and are in better nancial position as compared to rms with below median values of Short. This
is consistent with the central prediction of Diamond (1991) that rms with good credit quality are
more likely to issue short-term debt.
Overall, the results in Panels B and C of Table 1 indicate that rms with more short-term debt are
better rms based on observable characteristics but experience more severe rating downgrade within
a year. This is consistent with both the liquidity risk hypothesis and the alternative explanations.
We now turn to formal multivariate analysis that will help distinguish between the two.
3.1.2 Regression Results
We now perform multivariate tests to investigate whether rms with a higher proportion of debt
maturing in the short term are likely to experience more severe rating downgrade. To this end,
we estimate the panel OLS regression (2) with Notches Downgrade as the dependent variable and
lagged values of Short as the main independent variable. We include rm and year xed eects
in all specications. The standard errors are robust for heteroscedasticity and autocorrelation and
clustered at the individual rm level. The results are presented in Panel A of Table 3.
In Column (1), we estimate the regression on all the rms in our sample. The positive and
signicant coecient on Short indicates that rms with a higher proportion of short-term debt
experience more severe rating downgrades. Since we have rm xed eects in the specication,
the coecient measures the correlation between within-rm changes in the proportion of short-
term debt and rating downgrade severity. The coecient is also economically signicant: a one-
standard-deviation increase in Short is associated with an increase of 0.0714 in the number of notches
downgrade. In comparison, the sample mean value of Notches Downgrade is 0.205.
In terms of the coecients on the control variables, the insignicant coecients on Size (1), Size
(2) and Size (3) indicate that rm size does not aect the severity of rating downgrades. Furthermore,
we nd that rms with smaller market-to-book ratios, those with less idiosyncratic risk and those with
investment-grade credit ratings are more likely to experience multi-notch downgrades. These results
14
indicate that the rms that experience multi-notch downgrades are not the riskier rms in terms
of observable characteristics. These results are consistent with our univariate results. We further
nd that rms that experience multi-notch downgrades have lower cash balance (negative coecient
on Cash/TA), lower protability (negative coecient on Operating Income/Sales), higher leverage
(positive coecient on Total Debt/Market Value) and lower interest coverage (negative coecient
on Interest Coverage). All these indicate that such rms experience a deterioration in credit quality.
In Column (2), we repeat the estimation after including dummy variables to represent the 22 rating
categories and obtain similar results.
As noted earlier, the choice of debt maturity structure is likely to be determined by rm charac-
teristics such as rm size and credit quality, which may also aect the severity of rating downgrade.
For instance, small rms rely more on short-term debt (Barclay and Smith (1995)) and are also more
likely to be nancially constrained (Rauh (2006)), which may make them more likely to experience
severe rating downgrades. Although we control for rm size in our estimation and nd the coecient
to be insignicant, to further test if our results are driven by a subset of rms, we repeat our esti-
mation separately in Columns (3) and (4) on subsamples of small and large rms. We identify small
(large) rms as those with below (above) sample median book value of total assets. As can be seen,
the positive association between the proportion of short-term debt and severe rating downgrades is
present for both small and large rms.
In a similar vein, in Columns (5) and (6) we repeat the estimation separately in subsamples of
investment-grade (S&P credit rating of BBB- or better) and below investment-grade rms. As can
be seen, the positive association between the proportion of short-term debt and the severity of rating
downgrades is present for both above and below investment-grade rms.
Even if rating agencies do not change a rms credit rating, they frequently issue a negative
(positive) outlook to signal deterioration (improvement) in the rms credit quality. To test if rating
agencies anticipate the liquidity risk facing rms with a higher proportion of short-term debt and
issue a negative outlook in anticipation of severe rating downgrade, in unreported tests we control
for the issuance of a negative outlook. Our results are similar to the ones reported here. We nd
an insignicant relationship between the issuance of a negative outlook and the severity of rating
downgrade. Also, ratings are likely to be particularly sticky around the investment-grade cuto,
because a downgrade to below investment grade imposes large costs on regulated institutions such
as insurance companies (Ellul et al. (2009)). Such institutions may be forced to sell the bonds at
15
signicant discounts due to their poor liquidity. Hence, rating agencies may be particularly sensitive
to avoid rating volatility around the investment-grade threshold. In unreported tests, we control for
instances when the rms lagged credit rating is at the investment-grade threshold (i.e., BBB-) and
obtain similar results.
Overall, our results in Panel A show that rms with a higher proportion of short-term debt are
more likely to experience severe rating downgrade. This result is consistent with such rms having
greater exposure to the liquidity risk arising from short-term debt.
In Panel B, we repeat our estimation with Multi-notch Downgrade as the dependent variable.
As mentioned, Multi-notch Downgrade is a dummy variable that identies instances of multi-notch
downgrades. The results in Panel B are qualitatively similar to those in Panel A, and indicate that
rms with a higher proportion of short-term debt are more likely to experience multi-notch rating
downgrades. The results are again economically signicant. The result in Column (2) indicates that
a one-standard-deviation increase in Short is associated with a 2.1% increase in the likelihood of a
multi-notch downgrade. In comparison, the average likelihood of a multi-notch downgrade in our
sample is 4.4%. In unreported tests, we nd similar results when we repeat the regression with
Triple-notch Downgrade, a dummy variable that identies downgrades of at least three notches, as
the dependent variable.
Next, we examine how the positive association between severity of rating downgrade and rms
reliance on short-term debt varies with industry, rm and macroeconomic characteristics. The results
of our estimation are presented in Panel C. Our set of control variables in this panel are similar to
those in Panels A and B, but to conserve space we do not report the coecient estimates on all
the control variables. In Column (1), we repeat our estimates from Column (1) of Panel A for
comparison. In Column (2), we examine if the positive association between the severity of rating
downgrade and a rms reliance on short-term debt is stronger when the rm experiences a negative
shock to its protability. We identify a negative shock to protability from declines in industry
protability. Specically, we identify industry at the level of two-digit SIC code and measure the
industry protability as the median Operating Income/Sales of all rms in the industry. We code the
dummy variable Prot Decline equal to one for rms in an industry in a given year if that industry
experiences a decline in protability from the previous year. As can be seen, a negative shock to
protability not only increases the likelihood of a multi-notch downgrade (positive coecient on
Prot Decline), but this increase is higher for rms with a higher proportion of short-term debt
16
(positive coecient on Prot Decline Short). This is consistent with the idea that liquidity risk
arising form short-term debt exacerbates the impact of negative operating shocks.
On a similar note, in Column (3) we test to see if the eect of short-term debt on the severity
of rating downgrade is stronger during recessions. We use the data on the NBERs website and
classify the years 1981, 1982, 1990, 1991 and 2001 as recessionary during our sample period. We
then repeat our estimation after including a dummy variable Recession that identies the recession
years and an interaction term Recession Short. Our results in Column (3) indicate that while
rating downgrades are no more severe during recessions, the eect of short-term debt on the severity
of rating downgrade is greater during recessions (positive coecient on Recession Short).
In Column (4), we examine the impact of credit market conditions on the association between the
proportion of short-term debt and severe rating downgrade. Following Hartford (2005), we measure
credit market conditions using the spread between the prime rate on bank loans and the federal
funds rate. We obtain data for both variables from the Federal Reserve Board website. We code the
variable High Bank Spread equal to one for the years in which the bank spread is above the sample
median. We repeat our estimation after including both High Bank Spread and an interaction term
High Bank Spread Short. The positive coecient estimates on both these terms indicate that not
only is the severity of downgrade greater in years of high bank spread but the association between
the proportion of short-term debt and severe rating downgrade is also stronger. This oers strong
evidence that credit market conditions may aect a rms liquidity risk by aecting the likelihood
and terms at which it can renance its short-term debt.
3.2 Liquidity Risk or Operating Risk?
In this section, we perform tests to see if the positive association between Short and severe rating
downgrade is due to liquidity risk or operating risk. As explained, we exploit the asymmetry in
the eect of liquidity risk in comparison to operating risk to distinguish the two. That is, liquidity
risk should only matter on the downside and hence should predict a positive correlation between
the proportion of short-term debt and the severity of rating downgrade. In contrast, operating risk
should matter both on the upside and downside and should predict a positive correlation between
short-term debt and severity of both rating upgrade and downgrade. To exploit this dierential
prediction, in Table 4 we use (2) and relate the proportion of short-term debt to the extent of rating
17
upgrade. The dependent variable in this table is Notches Upgrade, which is the maximal number of
notches by which a rms credit rating is upgraded during any month of the year. Otherwise, the
specication is identical to the one in Table 3. The results indicate that in all but one specication,
the coecient on Short is either insignicant or negative. This nding indicates that the positive
association between the proportion of short-term debt and severe rating downgrade is more consistent
with liquidity risk as opposed to operating risk.
3.3 Is Endogeneity Driving Our Results?
As we noted earlier, the maturity structure of corporate debt is endogenous. While we have controlled
for observable rm characteristics known to aect rms debt maturity choice such as rm size, growth
opportunities, volatility and asymmetric information, it is possible that our results are driven by
some unobserved rm characteristic that determines both the proportion of short-term debt and
the severity of rating downgrade. Such an unobserved variable, if existing, should be time varying
because we have rm xed eects in our specications. In this section, we report the results of
additional tests that help address this potential endogeneity problem. We do two sets of tests to
help control for potential endogeneity. In the rst set of tests, instead of the proportion of short-term
debt, we use the proportion of long-term debt due within one year (Compustat item dd1) as our
main independent variable. In the second set of tests, we employ an IV estimation.
In Panel A of Table 5, we repeat the estimation of (2) with Long-Term Debt Due/Total Debt
as the main independent variable. Long-Term Debt Due/Total Debt is the ratio of long-term debt
due within one year to total debt. Note that similar to short-term debt, a higher proportion of
long-term debt due within a year is also likely to lead to greater liquidity risk. Since the proportion
of long-term debt due within a year is likely to depend on the rms long-term debt structure and its
repayment schedule, both of which are likely to have been determined in the past, this measure is less
likely to systematically identify riskier rms (see Almeida et al. (2009) for a similar argument). The
results in Panel A indicate that in all our specications, the coecient on Long-Term Debt Due/Total
Debt is positive and signicant, indicating that rms with a higher proportion of long-term debt due
within a year are more likely to experience severe rating downgrades. This evidence highlights that
endogenous choice of debt maturity structure is unlikely to drive our results.
In Panel B of Table 5, we directly deal with the potential endogeneity problem by using instru-
18
mental variable (IV) regressions. We instrument Short with three instruments, namely the 10-year
treasury rate (10-Year T-Rate), and Log(Vega) and Log(Delta) both of which are calculated from
the CFO compensation data. Log(Delta) is the natural logarithm of the delta of the CFOs annual
compensation and Log(Vega) is the natural logarithm of the vega of the CFOs annual compensation.
The identifying assumption behind 10-Year T-Rate is that rms are more likely to issue short-term
debt when long-term interest rates are high (i.e., the market timing argument of Baker et al. (2003),
Barclay and Smith (1995), and Guedes and Opler (1996)), but that 10-Year T-Rate should not have
a direct impact on the severity of rating downgrade. The identifying assumption behind Log(Delta)
and Log(Vega) is that a compensation contract that provides incentives for the CFO to take on more
risk as characterized by a higher vega and/or a lower delta should also provide incentives to the CFO
to take on a higher proportion of short-term debt. Consistent evidence is provided by Chava and
Purnanandum (2009) who show that a rms proportion of riskier debt increases with CFOs vega
and decreases with CFOs delta. But the structure of CFO compensation should not directly aect
the severity of rating downgrade. We obtain CFO compensation data from Standard and Poors
Execucomp for the time period 1992-2008. We identify the CFO from the annual title of the top 5
ocers (Execucomp item titleann). Specically, we search the annual title and include all executives
with treasurer, nance, controller, vp-nance, or CFO in their title. We then construct delta and
vega for CFO compensation following Core and Guay (1999).
The results of our IV estimation in Column (2) show that the coecient on Short is positive
and signicant. Interestingly, when we employ the IV approach, the magnitude of the coecient
estimation is signicantly higher than that in Column (1) that is estimated as an OLS. This indicates
that endogeneity in rms debt maturity structure is likely to attenuate our coecient estimates. This
is reasonable because as seen from our univariate results, the larger, less risky and more protable
rms are more likely to have a higher proportion of short-term debt. These rms are less likely to
experience severe rating downgrade. Thus, when we control for this potential endogeneity in our
IV estimation, we obtain much larger eect of the proportion of short-term debt on the severity of
rating downgrade.
3.4 Short-Term Debt and the Firms Propensity to Default
Our results so far show that rms with a higher proportion of short-term debt are more likely to
experience severe rating downgrade. While this evidence is consistent with credit rating agencies
19
systematically underestimating liquidity risk, given that downgrades themselves happen at the dis-
cretion of the rating agencies, another possible interpretation of this nding is that rating agencies
are tougher on rms that have a larger proportion of short-term debt and downgrade them more
severely. This is likely to happen if rating agencies correctly recognize that such rms are riskier.
This is similar to the argument proposed in Blume et al. (1998). Note that this argument does
not invalidate our point that even among similarly rated rms, those with a higher proportion of
short-term debt are riskier.
One way to dierentiate between these competing explanations is to examine if the proportion
of short-term debt aects the likelihood of defaults. Since defaults are not at the discretion of rating
agencies and happen automatically when the rm is either liquidity constrained or insolvent, this
will help distinguish between the two explanations. Specically, we examine if rms with a higher
proportion of short-term debt are more likely to default on their long-term debt obligations after
controlling for lagged rating status. To do this, we estimate (2) with Default as the dependent
variable, where Default is a dummy variable that identies rms that are downgraded to rating of
D in a year. The results of our estimation are presented in Table 6.
In Columns (1) and (2), we estimate panel OLS regressions on our entire sample of rms. In
addition to year xed eect, in Column (1) we employ industry xed eects at the level of the
four-digit SIC code, and in Column (2) we employ rm xed eects. The positive and signicant
coecient estimates on Short indicate that rms with a higher proportion of short-term debt are
more likely to default. The coecient is also economically signicant: a one-standard-deviation
increase in Short is associated with a 0.52% increase in the propensity to default. In comparison, the
sample average probability of default is just 0.5%. In Columns (3) and (4), we repeat the estimation
in Column (2) separately on the subsamples of small and large rms, respectively. In Column (5),
we estimate a Cox-Hazard Model on the entire sample of rms, and in Column (6) we estimate a
logistic specication. In all specications, other than that in Column (4), the coecient estimates
on Short are positive and signicant. Overall, the results in Table 6 indicate that rms with a higher
proportion of short-term debt are more likely to experience default, even after controlling for their
current credit rating. This oers further support to our thesis that rating agencies underestimate
liquidity risk.
20
4 Conclusion
In this paper we test to see if rating agencies adequately take into account the liquidity risk of short-
term debt and nd that they do not. We provide two pieces of evidence to support this contention.
First, we nd that long-term bonds of rms with a higher proportion of short-term debt have higher
yields after controlling for all known determinants including their credit ratings. Second, we show
that rms with a higher proportion of short-term debt are more likely to experience severe rating
downgrade within a year, suggesting that rating agencies are more likely to be surprised by the
deterioration in the rms credit quality. We nd that our results are not driven by operating risk
or by the endogenity of a rms debt maturity structure.
Recent studies on rating agencies have focused on how the distorted incentives of the agencies
in rating structured investment products results in inated ratings that may not truly reect the
instruments default risk. Our analysis, on the other hand, indicates that the problems with the
rating process may not be conned to rating of structured investment products. We show that the
rating agencies need to pay greater attention to the ner aspects of a rms capture structure, such
as the maturity structure of its liabilities. While our current analysis is agnostic about the reason
why rating agencies underestimate liquidity risk arising from short-term debt, in future we hope to
explore that issue. The higher yield on long-term bonds for rms with greater short-term debt is an
important cost of short-term debt which rm managers need to take into account while determining
debt maturity structure.
21
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24
Appendix: Variable Denitions
The variables used in the empirical analysis are dened as follows:
Size: natural logarithm of book value of total assets.
Size (i), i {1, 2, 3}: size d
i
, where d
i
is a dummy variable that takes the value 1 if the rms book
value of total assets belongs to the iths tercile of its distribution, and 0 otherwise.
Market-to-Book:
book value of total assets book value of equity + market value of equity
book value of total assets
.
R&D/TA:
R&D expenditures
book value of total assets
.
Investment Grade: dummy variable that takes the value 1 if a rms credit rating is BBB- or better,
and 0 otherwise.
Rating
t1
: S&P long-term credit rating of the rm in the previous year coded as follows: AAA = 1,
AA+ = 2, AA = 3, AA- = 4, A+ = 5, A = 6, A- = 7, BBB+ = 8, BBB = 9, BBB- = 10, BB+ = 11,
BB = 12, BB- = 13, B+ = 14, B = 15, B- = 16, CCC+ = 17, CCC = 18, CCC- = 19, CC = 20, C = 21,
D = 22.
Downgrade: dummy variable that takes the value 1 if Rating
t
> Rating
t1
.
Short:
current liabilities
current liabilities + long-term debt
.
Notches Downgrade: maximum number of notches by which a rms credit rating is downgraded during
any month of a year.
Multi-notch Downgrade: dummy variable that takes the value 1 if Notches Downgrade 2, and 0
otherwise.
Notches Downgrade (Conditional): maximum number of notches by which a rms credit rating is
downgraded during the year conditional on there being a downgrade.
Multi-notch Downgrade (Conditional): the value of Multi-notch Downgrade conditional on there being
downgrade during the year.
Operating Income/Sales:
operating income after depreciation
sales
.
Total Debt/Market Value:
total debt
market value of equity + book value of total liabilities
.
Long-Term Debt/TA:
long-term debt
book value of total assets
.
Interest Coverage:
operating income after depreciation + interest and related expense
interest and related expense
.
Industry Volatility: standard deviation of cross-sectional operating incomes of all rms in the same
industry, where industry is dened at the level of two-digit SIC code..
Idiosyncratic Volatility: standard deviation of daily excess returns relative to the CRSP value-weighted
index for each rms equity during a year.
Tangibility:
property, plant and equipment
book value of total assets
.
Cash/TA:
cash
book value of total assets
.
25
Prot Decline: dummy variable that takes the value 1 if the rms residing industry experiences a
decline in protability from the previous year, where industry is dened at the two-digit SIC code level
and protability is measured as the median value of
operating income after depreciation
sales
of all rms in that
industry, and 0 otherwise.
Recession: dummy variable that takes the value 1 for years 1981, 1982, 1990, 1991 and 2001, and 0
otherwise.
High Bank Spread: dummy variable that takes the value 1 for the years when the spread between the
prime rate on bank loans and the federal funds rate is above its sample median, and 0 otherwise.
Improve: dummy variable that takes the value 1 if the rms rating improves from below investment
grade to investment grade, and 0 otherwise.
Negative Outlook: dummy variable that takes the value 1 if S&Ps rating outlook for the rm is negative,
and 0 otherwise.
CP Spread: spread of commercial paper over (3-month) treasury bill rate.
CP Rating: dummy variable that takes the value 1 if the S&P short-term issuer credit rating is higher
than C, and 0 otherwise.
Average Excess Return: mean of daily excess returns relative to the CRSP value-weighted index for
each rms equity over the 180 days prior to (not including) the bond transaction date.
Equity Volatility: standard deviation of daily excess returns relative to the CRSP value-weighted index
for each rms equity over the 180 days prior to (not including) the bond transaction date.
Average Index: mean of the CRSP value-weighted index returns over the 180 days prior to (not includ-
ing) the bond transaction date.
Systematic Volatility: standard deviation of the CRSP value-weighted index returns over the 180 days
prior to (not including) the bond transaction date.
Market Cap/Index:
market value of equity
CRSP valued-weighted index
.
Treasury Slope: 10-year treasury rate 2-year treasury rate.
Maturity: years to maturity.
Oering Yield: yield to maturity at the time of bond issuance.
Log(Amount): natural logarithm of bond issue size.
Debt Due in One Year:
long-term debt due in one year
total debt
.
26
Table 1: Summary Statistics
Panel A provides descriptive statistics of yield spreads (in basis points) for three categories of rms: nancial, utilities and
industrial. The data are collected from the Mergent Fixed Income Securities Database (FISD) for the period 1995-2008. For
each category, we split the sample into three subcategories depending on the rating of the rm: High-Rated (AAA, AA+, AA,
AA-), Medium-Rated (A+, A, A-) and Low-Rated (BBB+, BBB, BBB-). For each subcategory, we report the mean yield spread
of debts with short-term (maturity 7 years), Medium-Maturity (maturity (7 years, 15 years]) and Long-Maturity (maturity
(15 years, 30 years]), for subsamples of rms with proportion of short-term debt, as measured by Short, above or below its
sample median (High-Short and Low-Short, respectively). Panels B and C provide descriptive statistics of the rms. The data
are collected from Compustat and CRSP for the period 1980-2008. Panel B summarizes the full sample. Panel C divides the
full sample into two subsamples depending on whether the variable Short is below or above its sample median (Low-Short and
High-Short, respectively) and compares the two subsamples, unconditional and conditional on there being a rating downgrade.
Details on the denition of the variables are provided in the Appendix. Asterisks denote statistical signicance at the 1% (***),
5% (**) and 10% (*) levels.
Panel A: Yield Spread
Financial Firms
High-Short Low-Short High Low
High-Rated short-Maturity 74.583 72.810 1.773
High-Rated Medium-Maturity 97.138 92.111 5.027

High-Rated Long-Maturity 138.551 118.417 20.134

Medium-Rated Short-Maturity 89.397 77.638 11.759

Medium-Rated Medium-Maturity 108.407 108.412 -0.005

Medium-Rated Long-Maturity 147.204 135.428 11.776

Low-Rated Short-Maturity 154.589 133.548 21.041

Low-Rated Medium-Maturity 158.324 151.037 7.287

Low-Rated Long-Maturity 167.362 172.610 -5.248

Utilities
High-Short Low-Short High Low
High-Rated Short-Maturity 82.800 68.596 14.204

High-Rated Medium-Maturity 70.275 64.816 5.458

High-Rated Long-Maturity 147.484 125.078 22.406
Medium-Rated Short-Maturity 114.070 96.270 17.799

Medium-Rated Medium-Maturity 120.591 112.993 7.598

Medium-Rated Long-Maturity 165.186 137.516 27.670

Low-Rated Short-Maturity 120.017 121.353 -1.336

Low-Rated Medium-Maturity 144.010 131.332 12.678

Low-Rated Long-Maturity 176.548 156.339 20.209

Industrial Firms
High-Short Low-Short High Low
High-Rated Short-Maturity 60.701 51.444 9.257

High-Rated Medium-Maturity 66.218 57.784 8.433

High-Rated Long-Maturity 98.177 82.928 15.249

Medium-Rated Short-Maturity 83.735 77.970 5.765

Medium-Rated Medium-Maturity 92.849 91.658 1.191

Medium-Rated Long-Maturity 134.181 125.781 8.400

Low-Rated Short-Maturity 141.781 135.131 6.651

Low-Rated Medium-Maturity 148.373 149.551 -1.178

Low-Rated Long-Maturity 205.143 194.037 11.106

27
Panel B: Descriptive Statistics for the Full Sample
N Mean Median S.D.
Size 25142 8.015 7.864 1.661
Market-to-Book 25140 1.456 1.218 0.759
R&D/TA 25142 0.012 0 0.029
Rating
t1
25142 9.245 9 3.764
Investment Grade 25142 0.626 1 0.484
Downgrade 25142 0.133 0 0.339
Multi-notch Downgrade 25142 0.044 0 0.206
Notches Downgrade 25084 0.205 0 0.669
Multi-notch Downgrade (Conditional) 3332 0.317 0 0.465
Notches Downgrade (Conditional) 3332 1.547 1 1.137
Short 24801 0.190 0.093 0.236
Operating Income/Sales 25103 0.135 0.113 0.170
Total Debt/Market Value 24956 2.122 0.448 7.512
Long-Term Debt/TA 25133 0.282 0.260 0.195
Interest Coverage 23142 7.194 4.119 11.723
Industry Volatility 23908 0.114 0.091 0.076
Idiosyncratic Volatility 23459 0.023 0.019 0.014
Tangibility 25142 0.311 0.255 0.272
Cash/TA 25082 0.079 0.041 0.101
Panel C: Low-Short versus High-Short
Low-Short High-Short Low High
Size 7.440 8.606 -1.166

Market-to-Book 1.539 1.504 0.035

Rating
t1
10.470 7.985 2.485

Downgrade 0.131 0.136 -0.005

Multi-notch Downgrade 0.040 0.049 -0.009

Notches Downgrade (Conditional) 1.498 1.595 -0.097

Operating Income/Sales 0.119 0.152 -0.033

Total Debt/Market Value 0.916 0.922 -0.006

Long-Term Debt/TA 0.360 0.203 0.157

Interest Coverage 6.287 8.254 -1.967

Industry Volatility .117 .112 .005

Idiosyncratic Volatility .025 .021 .004

Tangibility .343 .277 .066

Cash/TA .081 .077 .004

28
Table 2: Bond Yield Spread and Short-Term Debt
This table reports the results of the regressions relating yield spread to the proportion of short-term debt: Spread
b,t
=
0
+
1

Short
i,t
+
2
Controls+Firm or Industry FE+Year FE. Details on the denition of the variables are provided in the Appendix.
Columns (1) and (2) report the results for the full sample, with Column (1) including year and industry xed eects and Column
(2) including year and rm xed eects. Columns (3) and (4) report the results for the subsamples of small rms and large rms,
respectively, where small (large) rms are those with size (as measured by book value of total assets) below (above) the sample
median. Columns (5) and (6) report the results for the subsamples of rms with high ratings (ratings better than sample median)
and low ratings (ratings worse than sample median), respectively. Robust standard errors, reported in parentheses, are clustered
at individual rm level. Asterisks denote statistical signicance at the 1% (***), 5% (**) and 10% (*) levels.
All Firms - OLS Small Large High-Rated Low-Rated
(1) (2) (3) (4) (5) (6)
Short .002 .002 .004 .0008 .003 .003
(.0009)

(.0008)

(.001)

(.001) (.0007)

(.001)

Idiosyncratic Volatility .154 .065 .043 .024 -.002 .032

(.034)

(.038)

(.057) (.072) (.048) (.069)

Systematic Volatility .319 .326 .333 .278 .174 .535
(.039)

(.038)

(.050)

(.047)

(.035)

(.058)

Long-Term Debt/TA -.002 .003 .010 -.003 .004 -.0003

(.002) (.002)

(.004)

(.002) (.002)

(.003)
Average Index -1.273 -1.338 -1.115 -1.637 -1.206 -1.636
(.112)

(.106)

(.130)

(.163)

(.116)

(.208)

Average Excess Return -.720 -.123 -.195 .036 -.190 -.034

(.208)

(.105) (.154) (.147) (.126) (.146)

Market Cap/Index -.146 -.404 -.343 -1.270 -.234 -1.540
(.035)

(.075)

(.076)

(.197)

(.046)

(.293)

Operating Income/Sales -.002 -.002 -.004 -.0009 -.003 -.001

(.001) (.002) (.003) (.002) (.002) (.003)
Total Debt/Market Value .00004 .0006 .0004 .002 .0003 .0007
(.0002) (.0002)

(.0002)

(.0007)

(.0001)

(.0003)

Treasury Slope -.0005 -.0006 -.0004 -.0007 -.0005 -.0009

(.0003)

(.0002)

(.0003) (.0003)

(.0002)

(.0003)

Maturity .0002 .0002 .0002 .0002 .0002 .0002

(1.00e-05)

(7.81e-06)

(1.00e-05)

(1.00e-05)

(1.00e-05)

(1.00e-05)

Oering Yield .0009 .0007 .0006 .0008 .0006 .0007

(.00009)

(.00006)

(.00008)

(.00008)

(.00007)

(.00008)

Log(Amount) -.0006 -.0002 -.0001 -.0002 -.0002 -.0002

(.0002)

(.0001) (.0001) (.0002) (.0001) (.0002)

Const. .001 -.003 -.004 -.0001 .0002 .002
(.003) (.002)

(.003) (.003) (.002) (.003)

Obs. 49098 49098 24271 24827 28875 20223
R
2
.519 .631 .648 .625 .581 .642
29
Table 3: Severity of Rating Downgrade and Short-Term Debt
This table reports the results of the regressions relating rating downgrade to the proportion of short-term debt: y
i,t
=
0
+

1
Short
i,t1
+
2
X
i,t
+ Firm FE + Year FE, where y
i,t
is Notches Downgrade in Panel A, and Multi-notch Downgrade in
Panels B and C. Details on the denition of the variables are provided in the Appendix. In Panels A and B, Columns (1) and (2)
report the results for the full sample, Columns (3) and (4) report the results for the subsamples of small rms and large rms,
respectively, where small (large) rms are those with rm size (as measured by book value of total assets) below (above) the
sample median, and Columns (5) and (6) report the results for the subsamples of rm with investment-grade (rating BBB- or
above) and below investment-grade (rating below BBB-) ratings, respectively. Robust standard errors, reported in parentheses,
are clustered at individual rm level. Asterisks denote statistical signicance at the 1% (***), 5% (**) and 10% (*) levels.
Panel A: Notches Downgrade
All Firms All Firms Small Large Investment Below-Investment
(1) (2) (3) (4) (5) (6)
Short .301 .298 .302 .257 .224 .369
(.046)

(.045)

(.071)

(.065)

(.052)

(.101)

Size (1) -.0004 -.081 .004 -.004 .040

(.019) (.021)

(.027) (.025) (.030)

Size (2) .003 -.081 .008 .027 .0005 .044
(.018) (.020)

(.026) (.028) (.024) (.028)

Size (3) .005 -.074 .030 .004 .039
(.017) (.019)

(.027) (.022) (.026)

Market-to-Book -.085 -.107 -.085 -.096 -.080 -.081
(.012)

(.013)

(.020)

(.016)

(.016)

(.019)

Industry Volatility -.053 -.029 -.131 -.008 .014 -.075

(.107) (.106) (.152) (.163) (.128) (.171)
Idiosyncratic Volatility -3.682 .122 -3.260 -4.757 -.644 -3.943
(1.018)

(.684) (1.013)

(1.477)

(1.670) (1.233)

Tangibility -.017 -.077 .0008 -.027 -.014 .0004

(.044) (.047) (.060) (.063) (.055) (.072)
R&D/TA .178 -.424 -.794 .402 .344 -.729
(.595) (.589) (.939) (.850) (.896) (.922)
Long-Term Debt/TA .089 .268 .096 .106 .111 .149
(.074) (.078)

(.092) (.149) (.121) (.095)

Investment Grade .288 .231 .422
(.030)

(.038)

(.051)

Cash/TA -.288 -.207 -.357 -.119 -.034 -.359

(.093)

(.094)

(.114)

(.174) (.131) (.126)

Operating Income/Sales -.442 -.524 -.423 -.563 -.870 -.253

(.097)

(.094)

(.105)

(.206)

(.205)

(.096)

Total Debt/Market Value .006 .010 .011 .004 .004 .009

(.002)

(.002)

(.005)

(.002) (.002)

(.004)

Interest Coverage -.002 -.003 -.001 -.001 -.001 -.002

(.0005)

(.0006)

(.0008)

(.0008)

(.0007)

(.0009)

Const. .257 1.936 .366 -.189 .303 .124

(.155)

(.233)

(.209)

(.251) (.198) (.231)

Obs. 20258 20258 10481 9777 12592 7666
R
2
.223 .268 .314 .201 .212 .361
30
Panel B: Multi-notch Downgrade
All Firms All Firms Small Large Investment Below-Investment
(1) (2) (3) (4) (5) (6)
Short .091 .087 .095 .075 .065 .114
(.015)

(.015)

(.023)

(.021)

(.018)

(.031)

Market-to-Book -.019 -.024 -.019 -.021 -.019 -.018

(.004)

(.004)

(.007)

(.005)

(.005)

(.008)

Industry Volatility -.049 -.042 -.074 -.049 -.046 -.059

(.034) (.034) (.048) (.054) (.042) (.056)
Idiosyncratic Volatility -.690 -.039 -.662 -1.086 .512 -.821
(.236)

(.269) (.244)

(.433)

(.520) (.272)

Tangibility .005 -.010 .014 -.003 .012 .015

(.014) (.014) (.018) (.019) (.016) (.024)
R&D/TA .016 -.141 -.224 .374 -.076 -.197
(.195) (.202) (.264) (.368) (.287) (.244)
Long-Term Debt/TA .019 .061 .031 .029 .021 .036
(.023) (.025)

(.032) (.044) (.042) (.032)

Investment Grade .075 .059 .116
(.010)

(.014)

(.017)

Cash/TA -.069 -.052 -.095 -.009 .034 -.106

(.032)

(.032) (.042)

(.054) (.046) (.043)

Operating Income/Sales -.103 -.119 -.106 -.087 -.174 -.052

(.025)

(.025)

(.032)

(.043)

(.049)

(.032)
Total Debt/Market Value .001 .002 .002 .0008 .0008 .002
(.0006)

(.0006)

(.001) (.0006) (.0007) (.001)

Interest Coverage -.0003 -.0006 -.00009 -.0003 -.0002 -.0003
(.0002) (.0002)

(.0003) (.0003) (.0002) (.0003)

Const. .063 .418 .125 -.096 .103 .068
(.044) (.057)

(.057)

(.084) (.072) (.061)

Obs. 20286 20286 10502 9784 12606 7680
R
2
.203 .24 .278 .194 .201 .332
Panel C: Additional Tests on Multi-notch Downgrade
(1) (2) (3) (4)
Short .301 .264 .270 .186
(.046)

(.047)

(.044)

(.068)

Prot Decline .019

(.010)

Prot Decline Short .087

(.052)

Recession -.035
(.040)
Recession Short .156
(.078)

High Bank Spread .090

(.044)

High Bank Spread Short .148

(.064)

Const. .257 .259 .253 .201

(.155)

(.154)

(.155) (.136)
Obs. 20258 20258 20258 20258
R
2
.223 .223 .223 .223
31
Table 4: Rating Upgrade and Short-Term Debt
This table reports the results of the regressions relating rating upgrade to short-term debt: y
i,t
=
0
+
1
Short
i,t1
+
2

Controls
it
+ Firm F.E. + Year F.E., where y
i,t
is Notches Upgrade. Details on the denition of the variables are provided in the
Appendix. Columns (1) and (2) report the results for the full sample. Columns (3) and (4) report the results for the subsamples
of small rms and large rms, respectively, where small (large) rms are those with size (as measured by book value of total
assets) below (above) the sample median. Columns (5) and (6) report the results for the subsamples of rm with investment-grade
(rating BBB- or above) and below investment-grade (rating below BBB-) ratings, respectively. Robust standard errors, reported
in parentheses, are clustered at individual rm level. Asterisks denote statistical signicance at the 1% (***), 5% (**) and 10%
(*) levels.
All Firms All Firms Small Large Investment Below-Investment
(1) (2) (3) (4) (5) (6)
Short -.005 -.042 .049 -.042 -.095 .167
(.033) (.026) (.057) (.037) (.023)

(.096)

Market-to-Book .055 .079 .078 .035 .037 .068

(.010)

(.009)

(.016)

(.011)

(.009)

(.021)

Industry Volatility .051 .023 .127 -.009 .051 .170

(.078) (.071) (.111) (.118) (.082) (.155)
Idiosyncratic Volatility 1.845 -1.771 1.336 2.631 2.025 1.466
(.889)

(.693)

(.892) (1.280)

(.825)

(1.016)
Tangibility -.050 -.004 .007 -.074 -.065 -.027
(.030)

(.027) (.041) (.042)

(.026)

(.057)
R&D/TA -.159 .186 -.152 -.007 -.393 -.103
(.432) (.374) (.721) (.502) (.376) (.890)
Long-Term Debt/TA -.150 -.324 -.155 -.111 -.150 -.094
(.054)

(.048)

(.069)

(.099) (.052)

(.082)
Investment Grade -.338 -.316 -.316
(.028)

(.035)

(.050)

Cash/TA .128 .004 -.023 .370 .037 .098

(.074)

(.063) (.098) (.133)

(.064) (.129)
Operating Income/Sales .219 .262 .206 .242 .151 .254
(.042)

(.044)

(.053)

(.084)

(.045)

(.063)

Total Debt/Market Value -.001 -.003 -.003 -.0007 -.0009 -.003

(.0009) (.001)

(.001)

(.001) (.0008) (.002)

Interest Coverage -.0009 .0003 -.001 -.0008 -.0007 -.0007
(.0005)

(.0004) (.001) (.0005) (.0003)

(.002)
Const. .267 -1.276 .098 .301 .332 .155
(.122)

(.137)

(.172) (.137)

(.101)

(.219)
Obs. 20258 20258 10481 9777 12592 7666
R
2
.204 .357 .278 .195 .134 .296
32
Table 5: Addressing Potential Endogeneity Problem
We address potential endogeneity problem in this table. Panel A reports the results of the regressions relating rating downgrade
to the proportion of a rms long-term debt maturing within one year: y
i,t
=
0
+
1
Debt Due in One Year
i,t1
+
2

Controls
it
+ Firm F.E. + Year F.E., where y
i,t
is Multi-notch Downgrade. Columns (1) and (2) report the results for the full
sample. Columns (3) and (4) report the results for the subsamples of small rms and large rms, respectively, where small (large)
rms are those with size (as measured by book value of total assets) below (above) the sample median. Columns (5) and (6)
report the results for the subsamples of rm with investment-grade (rating BBB- or above) and below investment-grade (rating
below BBB-) ratings, respectively. In Panel B, we run instrumental variable regressions. Column (1) of Panel B displays the
results of the OLS regression performed in Column (1) of Panel B in Table 2. In Column (2), we use 10-year treasury rate,
natural logarithm of the delta of CFO compensation and natural logarithm of the vega of CFO compensation to instrument for
the variable Short. The regression in Column (2) apply industry and year xed eects, and he results are for all rms in our
sample. Details on the denition of the variables are provided in the Appendix. Robust standard errors, reported in parentheses,
are clustered at individual rm level. Asterisks denote statistical signicance at the 1% (***), 5% (**) and 10% (*) levels.
Panel A: Severe Rating Downgrades and Long-Term Debt Due within One Year
All Firms All Firms Small Large Investment Below-Investment
(1) (2) (3) (4) (5) (6)
Debt Due in One Year .059 .079 .100 .005 .0009 .150
(.023)

(.023)

(.038)

(.026) (.023) (.048)

Market-to-Book -.020 -.025 -.019 -.021 -.020 -.018

(.004)

(.004)

(.007)

(.006)

(.005)

(.008)

Industry Volatility -.057 -.049 -.083 -.053 -.058 -.043

(.036) (.036) (.051) (.056) (.047) (.055)
Idiosyncratic Volatility -.515 .003 -.500 -.845 .848 -.637
(.229)

(.282) (.242)

(.455)

(.549) (.267)

Tangibility .003 -.012 .013 -.005 .007 .014

(.014) (.014) (.019) (.020) (.016) (.025)
R&D/TA .0007 -.192 -.193 .118 -.038 -.144
(.194) (.199) (.268) (.325) (.309) (.249)
Long-Term Debt/TA -.029 .025 -.006 -.031 -.033 .008
(.025) (.025) (.034) (.044) (.042) (.035)
Investment Grade .079 .062 .119
(.010)

(.014)

(.017)

Cash/TA -.107 -.098 -.112 -.085 -.026 -.097

(.033)

(.033)

(.042)

(.056) (.046) (.044)

Operating Income/Sales -.117 -.129 -.130 -.081 -.188 -.065

(.028)

(.028)

(.034)

(.048)

(.057)

(.033)

Total Debt/Market Value .002 .003 .003 .001 .0009 .003

(.0007)

(.0007)

(.002)

(.0007) (.0008) (.001)

Interest Coverage -.0003 -.0006 -.00005 -.0002 -.0002 -.0004

(.0002) (.0002)

(.0003) (.0003) (.0002) (.0003)

Const. .106 .543 .124 -.027 .120 .061
(.053)

(.067)

(.060)

(.084) (.070)

(.063)
Obs. 18965 18965 9982 8983 11634 7331
R
2
.204 .243 .276 .2 .204 .335
33
Panel B: Instrumental Variable Regression
Multi-notch Downgrade
All Firms
OLS IV
(1) (2)
Short .091 .537
(.015)

(.242)

Market-to-Book -.019 -.023

(.004)

(.007)

Industry Volatility -.049 -.130

(.034) (.069)

Idiosyncratic Volatility -.690 .210

(.236)

(.444)
Tangibility .005 .028
(.014) (.021)
R&D/TA .016 .010
(.195) (.183)
Long-Term Debt/TA .019 .296
(.023) (.142)

Investment Grade .075 .017

(.010)

(.009)

Cash/TA -.069 .0003

(.032)

(.043)
Operating Income/Sales -.103 -.071
(.025)

(.032)

Total Debt/Market Value .001 -.003

(.0006)

(.004)
Interest Coverage -.0003 -.0002
(.0002) (.0003)
Const. .063 .064
(.044) (.136)
Obs. 20286 5311
R
2
.203 .
Fixed Eects Firm and Year Industry and Year
34
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