Corporate risk-taking after changes in credit rating

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Corporate risk-taking after changes in credit rating

Hardjo Koerniadi^*

Auckland University of Technology, Auckland, New Zealand

Abstract

This paper examines corporate risk-taking and the risk-taking mechanisms firms use following changes in their credit ratings. This paper finds that, while in general changes in credit rating is negatively associated with post-event risk-taking, firms downgraded to the investment grade level, do not increase their risk-taking. Only after firms are rated below this level, they significantly increase their risk-taking suggesting that the association between downgrades in credit rating and firm risk-taking after the event is not linear. Further analysis suggests that these firms do not use R&D expenses or capital expenditures as their risk-taking mechanism but utilise long-term debt, which is consistent with the conjecture to reduce rollover and default risks, as well as to improve asset values of financially distressed firms.

Keyword: risk-taking; credit rating; behavioural theory of firm; asset substitution theory; leverage

JEL codes: G30, G32, G40

*Auckland University of Technology; Faculty of Business, Economics and Law, Department of Finance, Private Bag 92006, Auckland 1142, New Zealand

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Corporate risk-taking after changes in credit rating

1. Introduction

Corporate risk-taking is a strategic decision that has significant impact on firm survival.

The main purpose of risk-taking is to increase the market value of a firm’s assets, which benefits the stakeholders of the firm, especially if it is a financially distressed firm (Koharki and Watson, 2019). Increasing risk, however, will automatically increase the firm’s operating and return volatilities. Therefore, risk-taking is desirable if it increases not only a firm’s volatility, but also the level of the firm’s assets values. Otherwise, it only increases the firm’s credit risk which can potentially create an asset substitution problem, that is problematic, particularly for financially distressed firms (Jensen and Meckling, 1976). Risk-averse managers, however, may not be willing to undertake necessary risky investments that can increase their firm value due to personal reasons such as undiversified wealth portfolio, career concern or other personal-related motivations. To encourage these managers to take on necessary risk, firms usually use option-based compensation packages as their risk-taking incentives.

Prior studies report that risk-taking incentives, proxied by option-based compensations, have significant impact on corporate decisions such as firm investments, cost of equity, pension policy, corporate governance and CSR (see e.g., Coles et al., 2006; Guay, 1999; Chen et al., 2015; Dunbar et al., 2017; Ashbaugh-Skaife et al., 2006; Anantharaman and Lee, 2014). Risk-taking incentives have also been documented to have significant relations with firm credit rating. Kuang and Qin (2013) find evidence consistent with credit rating agencies considering a firm’s risk-taking incentives in their risk assessment of the firm’s credit rating. They also find that when a firm experiences a downgrade in its credit rating to the investment grade level (BBB- ), it reduces its risk-taking incentive which is conveyed in its new option grants following this corporate event. The reduced incentive assumes that firms with their credit rating downgraded to investment grade are expected to reduce their risk-taking after this event.

Reducing risk-taking incentive after such a downgrade in credit rating, however, does not necessarily mean that the managers of these firms would follow the incentives to reduce their risk-taking after such a downgrade in their firms’ credit rating. This issue is important as relatively more recent empirical findings suggest that option-based

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compensation incentive may not be an optimal measure for managerial risk-taking incentive (Sanders and Hambrick, 2007; Dong et al., 2010; Billings et al., 2018). These studies find that option-based risk-taking incentives may cause managers to take on excessive or less than optimal risk-taking. Furthermore, since the adoption of FAS 123R in 2005, the relationships between risk-taking incentives and both investment and financial policies are reported to be insignificant (Hayes et al., 2012).

Up to date however, there has been no empirical study examining corporate risk-taking after a firm experiences a downgrade or a change in its credit rating. How corporates behave towards risk after a change or downgrade in their credit rating, therefore, is a question that warrants an empirical examination. Another important issue on corporate risk-taking after a downgrade in credit rating that is yet to be documented is that the relationship between rating downgrade and corporate risk-taking may be nonlinear. Firms downgraded to below the investment grade may have different behaviours towards risk-taking from those downgraded to this benchmark due to risk or survival concern. Therefore, in this paper, we attempt to address this issue by investigating corporate risk-taking following these three events: (1) after a firm experiences a change in its credit rating, (2) after its credit rating is downgraded to investment grade, and (3) after its rating drops below the investment grade. Examining corporate risk-taking after these changes in credit rating would give a more complete picture of corporate risk-taking behaviours following a change or a downgrade in credit rating. Given that option-based incentive may not be a good proxy for risk-taking incentive, and that our focus is not on the incentive itself, but on actual corporate risk- taking after changes in credit rating, in this study we do not examine risk-taking incentive variables, but use several proxies for risk-taking variables generally employed in the literature.

We find that, in general, an upgrade (downgrade) in credit rating is associated with a decrease (increase) in corporate risk-taking. We also document that, consistent with Kuang and Qin’s (2013) results, a downgrade in a firm’s credit rating to the investment grade level is not significantly associated with the firm’s risk-taking up to three years following this event. However, when a firm’s rating is downgraded below this grade, our results show that firms significantly increase their risk-taking. This result is consistent with the conjecture that a firm aspires to survive when its performance is extremely poor. In a further analysis we find that higher corporate risk-taking after a downgrade is not associated with increasing R&D expenses or capital expenditures but

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is attributed to higher leverage. This result is different from those documented in prior studies as our analysis includes or is more focused on downgraded firms, which are likely to face financial distress. We also document that the increase in leverage of these downgraded firms is attributed to higher long-term debt. This finding is related to the literature on theoretical studies on the optimal choice of debt maturity for financially constrained firms, where some studies suggest short-term debt as an optimal choice for risk-taking, while some others suggest long-term debt as the preferred option (see for example, Leland and Toft, 1996; Danielova et al., 2013; Wang and Chiu, 2019; Gopalan et al., 2014; Dangl and Zechner, 2016; Seta et al., 2019). As such, this study contributes to the literature not only by providing empirical evidence of corporate risk-taking after a change or downgrade in credit rating, but also is related to the optimal debt-maturity choice literature.

The rest of the paper is organised as follows. The next section discusses the theories on corporate risk-taking of firms under financial distress and highlights the hypotheses. Section 3 provides the methodology and the description of the sample.

Section 4 presents the empirical results and section 5 concludes.

2. Corporate risk-taking: Theoretical underpinnings and hypotheses

The literature provides several theories related to corporate risk-taking when a firm experiences poor performance. These theories, however, posit different risk-taking behaviours under such a condition. For example, the asset substitution theory predicts that when firms are in financial distress, they are likely to increase their risk-taking in order to survive. According to this theory, these firms increase their risk-taking by investing in risky projects that have high potential to generate cash flows large enough for the firms’ shareholders to make profit and get out of financial distress if these projects are successful. As firm shareholders’ downside risk is limited, bondholders will bear the losses if the projects fail. Thus, increasing risk when firms are in financial distress has the potential to shift bondholders’ wealth to that of shareholders’.¹ This increase in risk-taking behaviour when firms are in financial distress is also predicted by the behavioural theory of the firms. This theory suggests that when firms are performing below their aspirations, they will increase risk-taking. However, when firms

1 Koharki and Watson (2019) disagree with this notion and argue that increasing risk of financially distressed firms benefits not only the firms’ shareholders, but also debtholders of the firms.

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are in extreme poor performance, they are likely to gamble more for survival (Iyer and Miller, 2008). Thus, in the context of rating downgrade, both theories suggest downgraded firms are likely to increase their risk-taking. The debt overhang theory, on the other hand, suggests the opposite. This theory claims that financially distressed firms are likely to reduce their risk-taking. According to this theory, even though financial distressed firms may have positive NPV investment opportunities to invest in, if the cash flows generated from these projects are not large enough to get the firms out of the financial distress situation, these firms are reluctant to invest in those projects.

Therefore, as firm shareholders may not benefit from increasing risk-taking, this theory suggests that financial distressed firms may reduce, or at least not increase their risk- taking. A similar corporate risk-taking behaviour is also predicted by the prospect theory. This theory suggests that when a firm’s performance is extremely poor, it is likely to reduce risk-taking in order to survive (Chattopadhyay, Glick, & Huber, 2001).

As there could be two opposite risk-taking scenarios following a downgrade in credit rating, we do not take side on these conflicting theories and state our first hypothesis as:

H1: Firms increase or decrease their risk-taking after a change or a downgrade in its credit rating.

Kuang and Qin (2013) suggest that when a firm is concerned with its credit rating performance following a rating downgrade, it uses its risk-taking incentives embedded in its new option grants as the mechanism to reduce the firm manager’s risk-taking.

They find that when firms are downgraded to investment grade, firms reduce the incentive for their managers to take on more risk. However, whether firms actually reduce their risk-taking after such a downgrade is an empirical question. In addition to this issue, risk-taking after a downgrade in credit rating may not be linear. Firms downgraded to below investment grade experience more severe financial distress than those downgraded up to this rating grade. As the theories on risk-taking suggest different risk-taking behaviour of firms with extreme poor performance compared to those of moderately poor performance, these two types of downgraded firms can have different attitudes towards risk. Thus, our second hypothesis is:

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H2: Firms rated below the investment grade level have higher (lower) risk-taking than those rated to this grade after the downgrade.

Prior studies use several proxies for risk-taking mechanisms, such as R&D expenses, capital expenditures and leverage (see for example, Coles et al., 2006; Guay, 1999; Ryan and Wiggins, 2002; Faccio et al., 2016). The results, however, are still not conclusive. While earlier studies report a significant relation between risk-taking incentives and R&D expenses (Guay 1999 and Ryan and Wiggins, 2002), a recent study finds little evidence that R&D expenses are a good proxy for risk-taking (Bromiley et al., 2017). Coles et al. (2006) and Faccio et al. (2016) suggest that leverage is one of the mechanisms for a firm to implement its risk-taking. Kisgen (2006; 2009), however, finds that firms nearing their credit rating changes (upgrade or downgrade) issue less net debt. Nevertheless, as these risk-taking mechanisms are widely used as proxies for risk-taking, our study employs these risk-taking mechanisms in our analysis.

Consequently, our third hypothesis is:

H3: Corporate risk-taking after a change or downgrade in credit rating is reflected on either the firm’s leverage, R&D expenses, or capital expenditures.

3. Research design 3.1 Methodology

Changes in credit rating can have an impact on a firm’s risk-taking. On the other hand, corporate risk-taking can also affect the firm’s credit rating. In this study we examine corporate risk-taking after a firm experiences a change or downgrade in its credit rating and treat changes or a downgrade in a firm’s credit rating as given or exogenous.

Specifically, we focus on the firm’s risk-taking up to three years after a change in its credit rating (see Figure 1). Therefore, a reverse causality effect should not be an issue in our analysis.

Insert Figure 1 here

To examine if corporate risk-taking increases or decreases following a change or a downgrade in credit rating, we employ two measures of corporate risk-taking: (1) standard deviation of EBITDA three years after changes in credit rating and (2) standard

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deviation of monthly stock returns three years after changes in credit rating.

Accordingly, we estimate the following firm-fixed effect regression model:

∑

⁺ ⁺ ⁺

+ +

=

−Taking_i _t RATING_i_t CONTROL_i _t Year Effects Industry Effects _i _t

Risk _, α₀ _, _, ε _, (1)

where Risk-Taking is either the standard deviation of EBITDA or standard deviation of monthly stock returns three years after a change or downgrade in credit rating. RATING is either a change in credit rating (CHANGE), a downgrade to BBB- (BBBMIN), or a downgrade to below BBB- (BELOWBBBMIN). Control variables are MKTCAP which is natural logarithm of market capital, MB which is market to book ratio, TANGIBILITY which is fixed assets scaled by total assets, AGE which is the natural logarithm of 1 + number of firm years from the date of incorporation, ROA which is return on assets and INTERESTCOVERAGE which is interest coverage ratio.

We winsorise all control variables at the 1 percent and 99 percent percentiles to avoid the effects of outliers in our analysis.

In our third hypothesis, we examine how or what mechanism a firm utilises in implementing its risk-taking behaviour. Following prior studies, we examine leverage, cumulative R&D expenses or capital expenditures (all scaled by total assets) three years after a change in credit rating, as the instruments for implementing corporate risk- taking. Thus, we examine the following firm-fixed effect regression model:

∑

⁺ ⁺ ⁺

+ +

=

−TakingMechanism_i_t RATING_i_t CONTROL_i_t YearEffects IndustryEffects _i_t

Risk _, α₀ _, _, ε_, (2)

3.2. Sample

Following the literature on credit rating, we employ Standard & Poor’s Long-Term Domestic Issuer Credit Rating as the firm credit rating variable (Kuang and Qin, 2013;

Ashbaugh-Skaife et al., 2006). We collect this variable and the other firm variables of non-financial U.S. firms from Refinitiv Eikon database, formerly known as Thomson Reuters Eikon. We initially downloaded firm credit rating from 1970 to 2018 from this database. However, when we matched this data with other firm variables used in our analysis, matched data are available starting only from 1980. Therefore, we adjust our sample period from 1980 to 2018. Our unbalanced panel data sample consists of 2,459 non-financial U.S. firms from 1980 to 2018.

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Following prior studies (Kuang and Qin, 2013; Cheng and Subramanyam, 2008), we assign values from 1 to 20 to firm credit ratings where the lowest value (1) corresponds to the highest rating (AAA) and the highest value (20) to the lowest rating (D) and report the corresponding rating values in Table 1. Consequently, an upgrade (downgrade) in credit rating is associated with a negative (positive) value in a change in credit rating. In this study, we analyse corporate risk-taking: (1) after changes in credit rating, (2) after a rating downgrade to investment grade (BBB-) and (3) after a downgrade below the investment grade (below BBB-). Thus, we measure CHANGE as the change in rating value of credit rating for each firm year, BBBMIN as a dummy value of 1 when a firm is downgraded to BBB-, and BELOWBBBMIN as a dummy variable of 1 if it’s rating is downgraded to below BBB-.

Insert Table 1 here

Table 2 reports the descriptive statistics of the sample firms’ variables. On average, the sample firms experience a 0.05 point change or downgrade in their credit rating values. The maximum change in credit rating is a 15-point downgrade (a drop from 5 to 20) experienced by one company in 2001. Another company experienced the highest rating upgrade of 12-points (a jump from 20 to 8 points) in 2001. Around 0.8 percent of the sample were downgraded to investment grade, and 1.1 percent of the sample firms had their credit rating downgraded below the investment grade during the sample period. The average volatility of operating performance as measured by the standard deviation of EBITDA three years after the change in rating (STDEVEBITDA) is 0.03 and the average volatility of monthly stock returns three years after the rating change (STDEVRETURN) is 12.15 percent. About half of total assets of the sample firms are fixed assets (TANGIBILITY). The average age of the firms from the date of corporation is 16 years. The statistics show that, on average, the sample firms are able to meet their debt obligations with interest coverage ratio of almost 11 times and are profitable with ROA of 8 percent. Following a change in credit rating, around 35 percent of the sample firms’ assets are financed with leverage.² Cumulative capital

2 In the untabulated results, on average firms increase their leverage ratio by 0.017 one year after a change in credit rating (leverage ratio at time t+1, minus leverage ratio at time 0), and by 0.010 three years after a change in credit rating (leverage ratio at time t+3, minus leverage ratio at time 0). The increase in the leverage ratio is not due to decreasing assets as the average change in total assets is positive three years after the change in credit rating.

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expenditures and R&D expenses are, on average, around 20 to 18 percent of total assets, respectively.

4. Results

4.1. Corporate risk-taking and changes in credit rating

In this section, we will examine corporate risk-taking after a firm’s credit rating changes, after it is downgraded to investment grade and after it is rated below the investment grade.

4.1.1. Changes (upgrade and downgrade) in credit ratings

Table 3 reports the firm-fixed effect regression test results on the relation between risk- taking and changes in credit rating. The coefficients on CHANGE are significantly and positively related to both of our measures of corporate risk-taking, either assessed by the standard deviations of EBITDA or by standard deviations of monthly stock returns three years after the change in credit rating. This result suggests that when a firm’s credit rating is upgraded (downgraded), it is followed with a reduction (increase) in the firm’s risk-taking. This is consistent with the behavioural theory of the firms that when a firm’s performance is above its aspiration, it is likely to reduce risk, and vice versa.

Market capitalisation is positively correlated with standard deviation of EBITDA, and negatively correlated with standard deviation of stock returns. Younger firms and firms with more tangible assets are likely to have larger fluctuation in their operating profits, while profitable firms have low volatility in their stock returns.

Insert Table 3 here 4.1.2. Downgrade to investment grade

Kuang and Qin (2013) report that firms reduce their incentives to increase risk when its credit rating is downgraded to the investment grade level. They do not, however, empirically investigate if these firms actually reduce their risk-taking following the downgrade. This subsection examines this issue and reports our analysis in Table 4, which shows the results of firm-fixed effect regressions between firms’ credit rating downgraded to BBB- and corporate risk-taking three years after the downgrade. The

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coefficients on BBBMIN are positive, but not statistically significant, suggesting that when a firm’s credit rating is downgraded to the investment grade, it may become more prudent and refrain from engaging in a significant risk-taking, probably to keep its rating from going down further. This result complements Kuang and Qin (2013) that when a firm is downgraded to the investment grade level, this firm does not increase its risk-taking.

4.1.3. Downgrade to below investment grade

The literature on corporate risk-taking suggests that risk-taking could be nonlinear (Kahneman and Tversky, 1979). Firms with extreme level of poor performance can have a different attitude towards risk-taking from those with moderately lower performance. Therefore, firms downgraded to below the investment grade may have different risk-taking behaviours from those downgraded only to the investment grade.

Table 5 shows the firm-fixed effect regression test results when a firm’s credit rating is downgraded below the investment grade. We find that when a firm is rated below the investment grade, it is associated with a significant increase in its risk-taking measured up to three years after the downgrade. The larger the magnitude of the coefficients on BELOWBBBMIN than those on CHANGE and BBBMIN reported in Tables 3 and 4 suggest that these firms engage in more corporate risk-taking when their ratings are downgraded below the investment grade level, which is also consistent with the notion that these firms are likely to gamble in order to survive. In the next section we examine what mechanisms downgraded firms use to increase their risk- taking.

4.2. The mechanisms of corporate risk-taking and changes in credit rating

In this section we examine three possible mechanisms for corporate risk-taking. Our first proxy is cumulative asset-scaled R&D expenses three years after a change in credit rating. The literature documents that R&D expenses are related to risk-taking, suggesting that firms increase their risk-taking by investing more in R&D. A recent study by Bromiley et al. (2017), however, reports that R&D expenses are insignificantly

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related to risk-taking. Our second proxy is cumulative asset-scaled capital expenditures three years after a change in credit rating. Third, we employ the average of leverage ratio three years starting from a change in credit rating. We regress these mechanism proxies of risk-taking on changes in credit rating, a downgrade to BBB- and below BBB- and report the results in Table 6. To conserve space, we do not report the results on the control variables. Table 6 shows that all coefficients on RD3YR are statistically insignificant. The results suggest little evidence that firms use R&D expenses as their risk-taking mechanism when their ratings change. The results reported in Table 6 also suggest that, on average, an upgrade (downgrade) in credit rating is associated with higher (lower) capital expenditures, and a downgrade to BBB- rating and below are also associated with lower capital expenditures. This result is inconsistent with downgraded firms increasing risk-taking by increasing capital expenditures, but consistent with Khieu and Pyles (2016) that firms reduce their investments after their credit ratings are downgraded. Table 6 shows that the coefficients on the average of asset-scaled leverage ratio three years starting from a change in credit rating are significantly and positively related to changes in credit rating. This result suggests that when a firm’s credit rating is downgraded, it increases its leverage, therefore increasing its risk-taking. This is consistent with Danielova et al. (2013) that debt issues are positively associated with operating volatility and hence increase corporate risk-taking, especially for firms with lower credit rating.

4.3. Leverage and corporate risk-taking

In the previous section we document that downgraded firms are associated with significantly higher leverage three years after changes in credit rating. Dangl and Zechner (2016) argue that firms with low credit rating have a stronger motive to issue short-term debt because debt with short maturity commits the firms to reduce leverage should the firms go into bankruptcy. Financially distressed firms issuing short debt maturity, however, face with high rollover risk which can increase their default risk (Wang and Chiu, 2019; Seta et al., 2019; Gopalan et al., 2014). Seta et al. (2019) propose a model that, in the presence of financing frictions and when debts are fairly priced, short-term debt is associated with increase in risk-taking. They argue that increasing default risk would provide the firms’ incentives to increase risk-taking to

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improve firm performance and mitigate inefficient liquidation. Leland and Toft (1996) disagree with this conjecture and claim that as short-term debt reduces corporate risk- taking, firms in financial distress should issue long-term debt to increase asset volatility and, consequently, their firm values. Therefore, in this section we split leverage into short-term and long-term debts and examine whether the positive association between leverage and corporate risk-taking reported in Table 6 is attributed to short- or long- term debt.

Table 7 shows the results of firm-fixed effects regression tests between average short-term or long-term debt scaled by total assets three years after changes in credit rating. The coefficients on CHANGE are both significantly and positively related to both average short- and long-term debts three years since the change in credit rating.³ Thus, on average, the results show that firms increase (reduce) both short- and long- term debts when their ratings are downgraded (upgraded). However, when firms’

ratings are downgraded to BBB- and below, the results suggest that these firms respond by significantly increasing their long-term debt. Overall, the results suggest that when firms are rated to and below the investment grade, they increase their risk-taking by increasing long-term debt, most likely to reduce rollover and default risks, while at the same time increasing volatility which is expected to increase the firms’ asset values.

4.3. Robustness tests

For robustness tests, we employ two other alternative measures for corporate risk- taking. First, we use standard deviations of EBITDA five years after changes in credit rating (John et al., 2008). Second, we use dummy variables if the firm survives three years, and five years after changes in credit rating (Faccio et al., 2016). We find that the results, overall, are similar to the results reported in this study. Standard deviations of EBITDA five years after changes in credit rating are positively related to changes in credit rating, and changes in credit rating is positively related to both survive dummy variables and statistically significant for the three-year survive dummy. This result suggests that increasing risk-taking has positive effects to the survival of such firms.

3 To conserve space, we do not report the control variables, but available upon requests.

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We also employ several other proxies for corporate risk-taking mechanisms. We examine changes in R&D expenses, changes in CAPEX, changes in leverage and long- term debt, from the year a firm’s rating changes to three years after the event. We also use changes in leverage, long-term debt, R&D expenses, CAPEX from the year a firm’s rating changes to one year after this event. Additionally, we also use changes in firm investment, measured as changes in fixed assets one year after changes in credit rating.

We find the outcomes are still consistent with the conclusion of our analysis.

5. Conclusion

This paper examines corporate risk-taking following a change in a firm’s credit rating and which mechanism the firm uses to implement its risk-taking The findings suggest that, on average, an upgrade (downgrade) in credit rating is associated with a decrease (increase) in a firm’s risk-taking, three years after the change in rating. Larger increase in risk-taking is documented when firms are downgraded to below the investment grade level considered as facing a financial distress, consistent with the conjecture that financially distressed firms would take much higher risk to survive.

This paper also finds that downgraded firms do not use R&D expenses or capital expenditures as their mechanisms for risk-taking but employ long-term debt to increase risk which is expected to increase the firms’ asset volatilities as well as values. These findings are relevant to investors considering investing in downgraded-rating firms and to shareholders of such firms, especially those overseeing the firms’ risk-taking policies.

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Figure 1.

Corporate risk-taking prior to and after changes in credit rating.

Corporate risk-taking prior to Corporate risk-taking after Changes in credit rating

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Table 1. Values on Credit Rating

Rating Value Description

AAA 1 Prime

AA+ 2 High grade

AA 3

AA- 4

A+ 5 Upper medium

A 6

A- 7

BBB+ 8 Lower medium

BBB 9

BBB- 10 Investment grade

BB+ 11 Non investment grade

BB 12

BB- 13

B+ 14 Highly speculative

B 15

B- 16

CCC+ 17 Substantial risk

CCC 18

CCC- 19

CC 20 Extremely speculative

C 20 Default imminent

RD 20 In default

SD 20

D 20

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Table 2. Descriptive Statistics

Mean Median Min Max

CHANGE 0.049 0 -12 15

BBBMIN 0.008 0 0 1

BELOWBBBMIN 0.011 0 0 1

STDEVEBITDA 0.028 0.017 0.000 0.207

STDEVRETURN 12.150 9.968 3.244 55.471

MKTCAP 7.109 7.387 -3.912 11.862

MB 2.909 1.952 -13.164 32.865

TANGIBILITY 0.520 0.504 0.057 0.949

AGE 2.812 2.890 0.000 4.595

INTERESTCOVERAGE 10.895 3.337 -36.043 254.515

ROA 0.075 0.080 -0.392 0.339

LEVERAGE3YR 0.354 0.319 0.000 1.395

CAPEX3YR 0.205 0.150 0.007 0.110

RD3YR 0.181 0.108 0.002 1.086

CHANGE is a change in credit rating. BBMIN is a dummy variable of one if a firm’s credit rating drops to BBB-. BELOWBBBMIN is a dummy variable of one if a firm’s credit rating drops below BBB-. STDEVEBITDA is the standard deviation of a firm’s EBITDA three years after a change in credit rating. STDEVRETURN is the standard deviation of a firm’s monthly total stock returns three years after a change in credit rating. MKTCAP is the natural logarithm of firm market capital. MB is market to book ratio. TANGIBILITY is fixed assets scaled by total assets. AGE is the natural logarithm of 1 + number of firm years from the date of incorporation. INTERESTCOVERAGE is interest coverage ratio. ROA is return on assets.

LEVERAGE3YR is the average of asset-scaled leverage ratio three years from the change in credit rating. CAPEX3YR is cumulative asset-scaled capital expenditures three years after the change in credit rating and RD3YR is cumulative asset-scaled R&D expenses three years after the change in credit rating.

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Table 3. Regressions between Changes in Credit Rating and Corporate Risk- Taking

STDEVEBITDA STDEVRETURN

Coeff. p-value Coeff. p-value

CHANGE 0.001*** (0.000) 0.447*** (0.000) MKTCAP 0.003*** (0.000) -1.740*** (0.000)

MB 0.000 (0.126) 0.012 (0.128)

TANGIBILITY 0.008*** (0.000) 0.451 (0.288)

AGE -0.006*** (0.000) -0.429 (0.002)

ROA 0.003 (0.404) -5.681*** (0.000)

INTERESTCOVERAGE 0.000 (0.077) -0.001 (0.629) INTERCEPT 0.014*** (0.000) 26.790*** (0.000)

Industry effect Y Y

Year effect Y Y

N 21,561 17,540

R-square 0.029 0.424

Independent variable is either STDEVEBITDA or STDEVRETURN. STDEVEBITDA is the standard deviation of a firm’s EBITDA three years after a change in credit rating. STDEVRETURN is the standard deviation of a firm’s monthly total stock returns three years after a change in credit rating.

CHANGE is a change in credit rating. MKTCAP is the natural logarithm of firm market capital. MB is market to book ratio. TANGIBILITY is fixed assets scaled by total assets. AGE is the natural logarithm of 1 + number of firm years from the date of incorporation. ROA is return on assets.

INTERESTCOVERAGE is interest coverage ratio.

*** denotes statistical significance at the 1% level.

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Table 4. Regressions between Rating Downgrade to Investment Grade and Risk- Taking

Coeff p-value Coeff p-value

BBBMIN 0.001 (0.626) 0.344 (0.278) MKTCAP 0.002*** (0.000) -1.799*** (0.000)

MB 0.000* (0.096) 0.011 (0.159)

TANGIBILITY 0.008*** (0.000) 0.519 (0.222)

AGE -0.006*** (0.000) -0.401*** (0.005)

ROA 0.001 (0.727) -6.264*** (0.000)

INTERESTCOVERAGE 0.000* (0.08) -0.001 (0.624) INTERCEPT 0.015*** (0.000) 27.255*** (0.000)

Industry effect Y Y

Year effect Y Y

N 21,561 17,540

R-square 0.028 0.4214

BBBMIN is a dummy variable of one if a firm’s credit rating drops to BBB-. MKTCAP is the natural logarithm of firm market capital. MB is market to book ratio. TANGIBILITY is fixed assets scaled by total assets. AGE is the natural logarithm of 1 + number of firm years from the date of incorporation.

ROA is return on assets. INTERESTCOVERAGE is interest coverage ratio.

*,*** denotes statistical significance at the 10% and 1% levels respectively.

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Table 5. Regressions between Rating Downgrade to below Investment Grade and Risk-Taking

Coeff p-value Coeff p-value

BELOWBBBMIN 0.003** (0.028) 1.277*** (0.000) MKTCAP 0.002*** (0.000) -1.791*** (0.000)

MB 0.000* (0.099) 0.011 (0.159)

TANGIBILITY 0.008*** (0.000) 0.520 (0.221)

AGE -0.006*** (0.000) -0.393*** (0.006)

ROA 0.001 (0.672) -6.158*** (0.000)

INTERESTCOVERAGE 0.000* (0.082) -0.001 (0.604) INTERCEPT 0.014*** (0.000) 27.143*** (0.000)

Industry effect Y Y

Year effect Y Y

N 21,561 17,540

R-square 0.028 0.4216

BELOWBBBMIN is a dummy variable of one if a firm’s credit rating drops to below BBB-. MKTCAP is the natural logarithm of firm market capital. MB is market to book ratio. TANGIBILITY is fixed assets scaled by total assets. AGE is the natural logarithm of 1 + number of firm years from the date of incorporation. ROA is return on assets. INTERESTCOVERAGE is interest coverage ratio.

*,** and *** denotes statistical significance at the 10%, 5% and 1% levels respectively.

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Table 6. The Mechanisms of Corporate Risk-Taking

RD3YR CAPEX3YR LEVERAGE3YR

CHANGE 0.000 -0.007*** 0.012***

(0.709) (0.000) (0.000)

BBBMIN -0.002 -0.018*** 0.014**

(0.781) (0.000) (0.050)

BELOWBBBMIN -0.007 -0.024** 0.036***

(0.318) (0.000) (0.000)

Industry effect Y Y Y

Year effect Y Y Y

Independent variable is either RD3YR, CAPEX3YR or LEVERAGE3YR. RD3YR is cumulative asset- scaled R&D expenses three years after the change or downgrade in credit rating. CAPEX3YR is cumulative asse scaled capital expenditures three years after the change or downgrade in credit rating.

LEVERAGE3YR is average leverage ratio three years starting from a change in credit rating. CHANGE is a change in credit rating. BBBMIN is a dummy variable of one if a firm’s credit rating drops to BBB- and BELOWBBBMIN is a dummy variable of one if a firm’s credit rating drops to below BBB-.

** and *** denotes statistical significance at the 5% and 1% levels respectively.

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Table 7. Credit Rating Changes and Debt Maturity

STDEBT3YR LTDEBT3YR

CHANGE 0.003*** 0.008***

(0.000) (0.000)

BBBMIN 0.004 0.017**

(0.306) (0.012)

BELOWBBBMIN 0.005* 0.038***

(0.096) (0.000)

Industry effect Y Y

Year effect Y Y

Independent variable is either STDEBT3YR or LTDEBT3YR. STDEBT3YR is average short-term debt scaled by total assets three years starting from a change in credit rating. LTDEBT3YR is average long-term debt scaled by total assets three years starting from a change in credit rating.

CHANGE is a change in credit rating. BBBMIN is a dummy variable of one if a firm’s credit rating drops to BBB-. BELOWBBBMIN is a dummy variable of one if a firm’s credit rating drops to below BBB-.

*,** and *** denotes statistical significance at the 10%, 5% and 1% levels respectively.