Major rating agencies—that is, Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings—have policies in place that limit a corporate issuer’s ability to be rated above its sovereign country debt. That is, sovereign debt ratings act as a rating “ceiling” for most corporate borrowers within their home country. Thus, during times of macroeconomic stresses that affect the creditworthiness of the home country, corporate issuers with similar credit ratings are likely to be downgraded as well, regardless of the underlying fundamentals of the corporate issuer. Moreover, the authors find that these rating agency policies affect higher-rated corporate issuers disproportionately more than lower-rated corporate issuers within the home country. This disproportionate impact has a number of real-world consequences on corporate finance policies at the micro level.

After a sovereign debt downgrade, the higher-rated cohort of corporate issuers within a country is more likely to be downgraded as well. Shortly after a downgrade, capital structure decisions within a corporate issuer change. First, annual capital expenditures drop meaningfully. Prior to a downgrade, higher-rated corporations average more than 26% of net investment (capex as a percentage of invested capital), but net investment is reduced by 8.9 percentage points (pps). Conversely, the lower-rated cohort reduces its net investment by only 2.6 pps. Second, net debt issuance is disproportionately affected as well. Immediately following a downgrade, the higher-rated cohort reduces net debt issuance from 7.5% of assets to 2.4%. The lower-rated cohort reduces net debt issuance by only 2.3 pps. Finally and importantly, yields of the higher-rated cohort increase by 34 bps more than their lower-rated peers within three months after a sovereign downgrade and by 61 bps within six months. In total, the authors find that firms rated at or above the sovereign debt are more likely to reduce investment and debt issuance and that their cost of borrowing increases after a sovereign debt downgrade.

Interestingly, the authors find that there are no discernible differences between the two cohorts in investment, debt issuance, or borrowing costs during times of sovereign fiscal difficulties that have not resulted in a sovereign debt downgrade. Thus, these capital structure decisions appear to be solely a result of the sovereign debt downgrade.

The authors exhaustively test, both through empirical testing and through statements by corporate managers, the hypothesis that local corporate issuers rated at or above the rating of the sovereign entity are disproportionately affected after a sovereign debt downgrade. Using data from 1990 through 2013, they identify nonfinancial firms from 80 countries that were affected by sovereign debt downgrades.

After identifying the higher-rated cohort (those issuers rated the same as or above the sovereign), the authors use a nonparametric matching technique to identify similar firms that are rated below the sovereign debt and peer firms. In an effort to ensure the two cohorts have similar characteristics, they control for size, industry, debt maturity, and other identifiable differences between the groups. Additionally, the authors test for government ownership, for “national champion” firms (those firms likely to have greater government exposure), and for potential differences in other macro factors independent of the sovereign debt downgrade and conclude that there are no discernible differences between the two cohorts. The higher-rated cohort includes 73 firm-year observations, whereas the lower-rated cohort contains 53 unique firm-year observations.

The authors convincingly show that the rating agency policies that restrict a local corporate issuer’s ability to be rated above its sovereign have broad economic and financial consequences. Certainly, these findings highlight the need for investors to perform macro-level/sovereign analysis as well as corporate-level fundamental analysis prior to investment.

It is not enough to get the underlying corporate credit call right; an investor must also be aware of the potential negative influences sovereign downgrades can have on local corporate issuers, particularly those issuers rated at or slightly above the rating of the sovereign.