The spillover effect of dishonesty across markets: PEP fund reallocation and bond rating

Firms altering the utilization of equity capital raised through private equity placements (PEPs) may be viewed as either lacking good faith or adapting to changing business conditions. We investigate how the debt market interprets the implications of these changes. Linking data on the change of PEP funds utilization with the bond rating of listed firms in China, we find that changes in PEP funds utilization lead to a significantly lower rating of bonds issued subsequently. The finding is robust to alternative sample selection schemes, alternative model specifications, and various endogeneity-mitigating approaches. The negative impact of changing the uses of PEP funds on bond rating is more pronounced for firms that are non-state-owned enterprises, younger, and more likely to default, for bonds with longer maturity and those traded in the market with more retail investors, issued after the regulatory limitation on the pledgeability lowly-rated bonds, issued by firms located in provinces with a worse reputation for dishonesty or legal protection for investors. Further analysis suggests that the change also widens the credit spread. Overall, our results provide empirical evidence that debt market participants price the dishonest behavior of issuers, even though the behaviors occur in another market.