A version of this paper was presented at the 6th annual Municipal Finance Conference at Brookings.
Theoretically, disclosure quality reduces the cost of debt by reducing uncertainty about future cash flows (Lambert et al., 2007). However, cross-sectional studies that empirically link disclosure quality to the cost of debt are subject to the concern that risky issuers tend to exhibit weak disclosure quality. Similarly, studies that examine changes in disclosure quality suffer the criticism that changing issuer economics drive both the disclosure change and the cost of debt change.
The municipal bond setting provides an opportunity to address these concerns and strengthen the link between disclosure quality and the cost of debt for several reasons. First, even without issuer-provided disclosures, some economic information that is relevant to issuers’ credit quality is publicly available. For example, changes in local house prices are observable and are correlated with the strength of the local economy (Campbell and Cocco, 2007; Standard & Poor’s, 2012). Although property tax collections are the largest own-source of revenues for most local governments and are responsive to changes in house prices, house prices are largely outside the control of city and county officials. Therefore, conditioning on changes in local house prices helps to satisfy the ceteris paribus condition when comparing weak disclosers to strong disclosers.
Second, the municipal setting lends itself to the clean measurement of significant aspects of financial disclosure quality. These aspects include: the accessibility, comprehensiveness, reliability, timeliness, and regulatory compliance of financial information. Moreover, the municipal disclosure environment is lower quality and exhibits greater cross-sectional heterogeneity than does the corporate setting. Finally, municipal bond insurance and disclosure quality are substitute mechanisms to lower the cost of debt. Therefore, we use bond insurance as an instrument for disclosure quality to help attribute our results to financial reporting choices.
Our objective is to identify issuers with similar downgrade probabilities that differ in their ex ante disclosure quality. Strong disclosure quality issuers have a history of providing information that reduces uncertainty and allows investors and rating agencies to better assess changes in default risk. Therefore, we expect stronger disclosure quality issuers to suffer less negative changes in the cost of debt than weaker disclosure quality issuers with a similar probability of downgrade (Sengupta, 1998).
To identify issuers with similar downgrade probabilities, we match general obligation issuers on: their beginning credit rating and the relative magnitude of changes in local house prices. This allows us to examine whether two issuers with the same credit rating, which differ in their disclosure quality, elicit different responses from the rating agencies to similar changes in the local economy.
We match issuers on their beginning credit rating because the rating provides an initial indication of the issuer’s ability to withstand an economic shock. Moreover, Standard & Poor’s (S&P’s) transition matrices show that ratings volatility varies across ratings classes. We then match issuers on relative changes in local house prices because the economy receives the single largest weight in S&P’s local government rating methodology and S&P identifies real estate values as a primary measure of economic strength (Standard & Poor’s, 2012).
To validate local house price changes as a proxy for economic strength, we show that local house price changes are strongly correlated with changes in local per capita income and population. Further, we illustrate that relative changes in property values are reflected in general obligation bond rating changes. In an average year, issuers in the most negative house price change decile are 3 times more likely to be downgraded within the next three years than are issuers in the most positive decile.
We use changes in issuer credit ratings as a proxy for changes in the cost of debt because ratings provide a relatively pure assessment of perceived default probability (Ashbaugh-Skaife et al., 2006). To validate this proxy, we provide descriptive evidence that the uninsured general obligation bonds of highly rated issuers trade at tighter spreads than bonds of lower- rated issuers. Moreover, among issuers with the same credit rating, stronger disclosure quality issuers’ bonds tend to trade at tighter spreads than those of weak disclosure quality issuers.
We use conditional logistic regressions that control for other factors that can mitigate or exacerbate the credit rating agency’s response to economic changes (e.g., budget surplus, fund balance, debt burden, etc.). We find that among issuers with the same beginning credit rating in the same local house price change decile, a one-standard deviation improvement in disclosure quality lowers the odds of downgrade by 47 percent and raises the odds of upgrade by 28 percent. This relation is pronounced for issuers in the two most negative house price change deciles for two consecutive years.
Because we condition on credit rating, it is unlikely that risk differences explain this disparity. Because we condition on house price changes, it is unlikely that the propensity of weak disclosers to experience negative economic outcomes explains this disparity.
Matching issuers on their credit rating and the change in local house prices — and measuring disclosure quality ex-ante — helps to address the endogeneity in the relation between disclosure quality and the cost of debt. However, it is possible that an omitted issuer characteristic that is positively correlated with disclosure quality (rather than disclosure quality itself) attenuates the impact of negative economic changes on issuer credit ratings. To strengthen our ability to attribute our results to disclosure quality, per se, we estimate instrumental-variable regressions. In our setting, a valid instrument is a variable that affects issuer downgrades and upgrades only through its effect on disclosure quality. Because the instrument does not independently affect upgrades or downgrades, this approach helps to isolate the effect of disclosure quality on changes in issuer credit ratings.
Our instrument, the percentage of the issuer’s outstanding bonds that are insured, must satisfy two conditions. First, bond insurance must be correlated with disclosure quality. In addition to our evidence of this correlation, prior literature documents that insurance and disclosure quality are substitute mechanisms to lower the cost of debt (Gore et al., 2004; Cuny, 2016). Second, bond insurance cannot directly affect subsequent changes in the issuer’s underlying credit rating. This condition is met because issuer credit ratings primarily measure an issuer’s probability of default. Insurance payouts are conditional upon issuer default and do not directly affect the underlying issuer’s probability of default.
After demonstrating that the percentage of bonds insured is a strong instrument for dis- closure quality, particularly before the 2010 bankruptcy of many bond insurers, our instrumented results corroborate those described above. Among issuers with the same beginning credit rating in the same local house price change decile, a one-standard deviation increase in instrumented disclosure quality is associated with an 81 percent reduction in the odds of downgrade and a 104 percent increase in the odds of upgrade. Together, these results corroborate the idea that strong disclosure quality attenuates the impact of adverse economic changes on issuer credit ratings.
This paper is novel in several respects. First, prior literature examines the capital market consequences of changes in disclosure choices (Baber and Gore, 2008) and the disclosure consequences of economic changes (Kido et al., 2012; Cuny, 2016). We instead treat disclosure quality as given and examine different rating agency responses to changing economic conditions. This approach is unique in both the corporate and municipal debt literature.
Second, this paper bridges the gap between two distinct streams of literature. Fama and French (1989) and Collin-Dufresne et al. (2001) document a negative relation between changes in the cost of debt and changes in economic conditions. Baber et al. (2013) document a negative relation between changes in the cost of debt and changes in disclosure quality. However, little evidence exists supporting the idea that disclosure quality moderates the negative relation between changes in the cost of debt and changes in the local economy.
The rest of the paper proceeds as follows: In Section 2, we develop hypotheses. Section 3 describes the data and defines the variables. Section 4 provides results and section 5 concludes.
Read the full paper here.
The authors did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. They are currently not an officer, director, or board member of any organization with an interest in this article.