An estimate of the signaling benefit of obtaining a bond rating for municipal borrowers

Extensive academic research has been conducted on the impact of a bond rating on the debt issuer's borrowing cost. None of the studies, however, has examined the magnitude of the benefit of acquiring a credit rating. The purpose of this paper is to examine the various issues concerning the benefit of acquiring a bond rating for municipal borrowers. By using a N-chotomous probit model, the underlying credit quality of the nonrated bonds is analyzed, and the bond ratings are predicted for them. With the predicted bond ratings on the nonrated bonds, a bond pricing model is then employed to estimate the signaling benefit of a bond rating. The data source and testing period is the new-issue general obligation bonds sold in Texas during 1979-1983. Bond issues with special state guarantee and/or bond insurance are excluded from the sample.

The empirical results indicate that the nonrated bonds with below-investment grade quality suffer a penalty yield of 62 basis points as compared to the otherwise comparable Baa rated bonds. The signaling benefit of a bond rating is examined by comparing the issuing cost difference between the rated Baa bonds and the nonrated bonds with Baa quality, net of rating fees. On average, a 45 basis point yield penalty is found to be imposed on the nonrated bonds. Also the signaling benefit is found to increase with the size of the market. Finally, Bond issues that are purchased by local investors and not to be reoffered in the secondary market are found to be not enjoying any significant signaling benefit from having a bond rating.