Investor-pays ratings and credit risk information: Evidence from China bond rating

This paper examines whether the ratings issued by China Bond Rating Co., Ltd. (CBR), the first credit rating agency in China to adopt the investor-pays model, more accurately reflect issuers' credit risk than those issued by traditional issuer-paid rating agencies. We find that CBR assigns more conservative credit ratings than issuer-paid agencies. More importantly, for the same issuer, the rating difference between CBR and issuer-paid agencies contains significant information about underlying credit risk. Specifically, the more conservative CBR's rating is relative to that of issuer-paid agencies, the higher the issuer's expected future default risk and the stronger the negative reactions of investors in both the stock and bond markets. These findings suggest that CBR's relatively conservative ratings contain incremental information about issuers' credit risk, while investors respond appropriately to such information. Further analysis shows that conflicts of interest between issuer-paid rating agencies and issuers are an important source of rating inflation in China's bond rating market. Moreover, the greater such conflicts are, the larger the rating difference between CBR and issuer-paid agencies and the stronger its predictive power for future default risk. This evidence suggests that inflated issuer-paid ratings obscure issuers' underlying credit risk. In contrast, we find no evidence that such inflated ratings reflect private information held by issuers in China's bond rating market.