The Impact of Beliefs on Credit Markets : Evidence from Rating Agencies

An open question in finance and economics is how the beliefs of agents in the economy affect the credit cycle and real economic activity. We analyze the impact of beliefs on credit market conditions in the context of credit rating agencies (CRAs). We measure CRAs’ subjective beliefs as the difference in forecasts of future aggregate credit spreads between CRAs and a consensus of other financial institutions. When CRAs are relatively more optimistic, they issue higher credit ratings even though their forecasts do not contain additional information regarding future credit market conditions. CRA optimism leads to lower initial yields and subsequent negative returns for newly issued bonds. In response to this mispricing, firms increase their debt, leverage, and investment, where the effects are most pronounced among rated firms. Overall, our analysis shows how beliefs drive aggregate financing and investment behavior through mispricing in credit markets