Do Credit Ratings Determine Capital Structure - Do Credit Ratings Determine Capital Structure

International Journal of the Economics of Business
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Do Credit Ratings Determine Capital Structure?
Amrit Judge & Anna Korzhenitskaya
To cite this article: Amrit Judge & Anna Korzhenitskaya (2022) Do Credit Ratings Determine
Capital Structure?, International Journal of the Economics of Business, 29:1, 89-118, DOI:
10.1080/13571516.2021.1961563
To link to this article: https://doi.org/10.1080/13571516.2021.1961563
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INTERNATIONAL JOURNAL OF THE ECONOMICS OF BUSINESS
2022, VOL. 29, NO. 1, 89–118
https://doi.org/10.1080/13571516.2021.1961563
Do Credit Ratings Determine Capital Structure?

Amrit Judgea and Anna Korzhenitskayab
a
Finance, Risk and Banking Division, Nottingham University Business School, Nottingham University,
Nottingham, UK; bFinance, Accounting, Systems and Economics Department, Faculty of Social
Sciences, University of Wolverhampton Business School, Wolverhampton, UK
ABSTRACT KEYWORDS
This paper examines whether the possession of a credit rating Capital structure; credit
has an impact on firms leverage ratio. The issue of access to alter- ratings; bond market access
native sources of debt finance has received special attention in
JEL CLASSIFICATION
the wake of 2007–2009 financial crisis when banks significantly G3; G32
cut back on loans and firms became credit-constrained.
Consequently, policy makers have been examining ways of facili-
tating access to non-bank finance. An overreliance on bank
sourced debt finance when credit markets tighten has the poten-
tial to slow down the speed of economic recovery. This paper
provides empirical evidence in support of the hypothesis that the
possession of a credit rating is associated with higher leverage
ratios. The effect for UK firms seems higher than that observed
for similar US firms. This might be because there is greater finan-
cial transparency in the US implying lower levels of information
asymmetry and so negating somewhat the effects of possessing
a rating.
1. Introduction
Access to debt finance has become one of the major issues of concern for finance
directors, trade bodies such as the Confederation of British Industry (CBI) and public
policy makers, such as the Bank of England since the 2007–2009 financial crisis. In
March 2009, the Confederation of Business Industry’s Access to Finance survey
reported that a net balance of 30% of companies indicated that financing conditions
had adversely affected their output over the past three months. Concerns about the
wider implications for the economy of the tightening credit conditions were also
raised by public policy makers. For example, researchers at the Bank of England,
Barnett and Thomas (2013), suggest that tighter credit conditions played a significant
role in explaining the weakness in output seen during the crisis. They find that
between 2007 and the third quarter of 2012 tightening credit supply could have
accounted for between a third and a half of the overall fall in GDP compared to its
CONTACT Amrit Judge Amrit.Judge@nottingham.ac.uk Finance, Risk and Banking Division, Nottingham
University Business School, Nottingham University, Nottingham, UK.
Supplemental data for this article is available online at https://doi.org/10.1080/13571516.2021.1961563.
ß 2021 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group
This is an Open Access article distributed under the terms of the Creative Commons Attribution-NonCommercial-NoDerivatives
License (http://creativecommons.org/licenses/by-nc-nd/4.0/), which permits non-commercial re-use, distribution, and reproduction in
any medium, provided the original work is properly cited, and is not altered, transformed, or built upon in any way.
90 A. JUDGE AND A. KORZHENITSKAYA
historic trend. This evidence suggests that the ease with which credit flows to the cor-
porate sector is an important driver of economic activity and that tighter credit condi-
tions during and after the financial crisis slowed the recovery in the UK economy by
constraining consumption and investment.
The corporate finance literature is replete with studies that investigate the determi-
nants of capital structure. Since the seminal work of Modigliani and Miller (1958) most
of the empirical research in this area has concentrated on the demand-side determi-
nants of capital structure, while very little emphasis has been placed on the role
played by the availability or supply of debt capital. The implicit assumption of the
prior empirical literature is that the supply of capital is infinitely elastic and firms’ bor-
rowing decision depends solely on the demand for debt with no role for the supply
side (Rajan and Zingales 1995; Frank and Goyal 2007). In a real world context, informa-
tion asymmetry and other market imperfections imply that the supply of capital is not
perfectly elastic and some firms might find themselves credit-constrained and unable
to raise the desired level of debt (Faulkender and Petersen 2006). It follows that these
firms could be significantly under-levered relative to those firms that are not faced
with supply-side constraints.
Only in the last decade and a half have researches recognised the importance of
the supply-side as a potential determinant of capital structure. Several recent studies
have argued that possessing a credit rating provides a ‘key which opens the door’ for
accessing the public debt markets and consequently facilitates the take-up of greater
leverage. For example, Faulkender and Petersen (2006), Mittoo and Zhang (2008),
Kisgen (2009) show that companies with a credit rating have access to greater sources
of debt, and consequently are more highly levered. Faulkender and Petersen (2006)
argue that in the presence of information asymmetry firms with a credit rating can
access the arm’s length capital markets and are able to borrow more and so conse-
quently face lower financial constraints. Leary (2009) finds that following the 1966
Credit Crunch in the United States, larger firms with access to public debt market
were less affected by contraction in loan supply due to their greater ability to substi-
tute toward arm’s length debt financing.
It would seem then that a credit rating can potentially provide several benefits to a
firm. It can widen the investor base and the greater transparency can improve the
pricing of debt. A credit rating provides an opportunity to enter foreign bond markets
and gain international visibility, thereby reducing the reliance on local banks. This is
especially important for UK corporates given the relatively small size of the local cap-
ital market relative to that in the US, which is the largest source of debt capital in the
world. Given these supply side benefits recent capital structure research suggests that
firms that possess a credit rating are likely to have higher leverage ratios than those
without one. We test this prediction using a sample of UK non-financial firms over the
period 1989–2010.
This paper by providing an additional and highly pertinent case study on the role
of credit ratings in determining firm financing decisions makes an important contribu-
tion to the empirical literature. Up till now the extant empirical literature on the role
played by credit ratings in determining capital structure has employed in the main
samples of US or Canadian firms (Faulkender and Petersen 2006; Mittoo and Zhang
INTERNATIONAL JOURNAL OF THE ECONOMICS OF BUSINESS 91
2008; Leary 2009), while paying little attention to the importance of having a credit
rating outside a North American context. Farrant et al. (2013) point out that corporate
bond issuance in the United Kingdom has increased significantly since the early 1990s.
They note that the stock of outstanding debt securities issued by UK companies rose
from around 10% of nominal GDP in 1992 to around 25% in 2012. Furthermore, they
find that bond issuance since 2009 was stronger than the average between 2003 and
2008. It would seem that the UK provides a very good setting to investigate the role
of access to public debt markets in determining capital structure choice. Furthermore,
this research is highly relevant in the context of the public policy debate on firms’
access to non-bank finance. During the financial crisis and for several years after the
peak of the crisis, the UK economy was subjected to a period of severe tightening of
credit market conditions resulting in a significant reduction in the availability of bank
credit and deterioration in the non-price terms and conditions of bank loans offered
to the corporate sector. Many firms, and in particular small and medium sized firms,
were starved of credit as banks restricted the level of lending. Public policy makers,
such as Adam Posen, former member of the Bank of England’s Monetary Policy
Committee, has suggested that UK firms are over reliant on the banks for their debt
funding (Posen 2009). Tight credit markets and the lack of debt funding diversification
coupled with the limited availability of non-bank sources of debt finance was deemed
to have held back the UK recovery. Butt and Pugh (2014) suggest that the tightening
in credit conditions have been one of the main headwinds stifling economic recovery
in the UK since the financial crisis. Using a range of econometric techniques, as well as
controlling for endogeneity, the empirical analysis in our paper provides strong evi-
dence that rated firms are more highly levered than their unrated counterparts. These
findings imply that public policy makers and perhaps the credit ratings agencies
should be looking at ways of improving access to bond markets for UK firms.
The rest of the paper is organized as follows. Section 2 presents a review of the
empirical literature with a particular focus on studies investigating the importance of
supply-side determinants of leverage. Section 3 describes our sample and the data
employed and presents empirical results obtained from pooled OLS and panel estima-
tion methods. In Sec. 4 we use instrumental variable and treatment effect regression
methods to control for a range of endogeneity related issues. Section 5 concludes.
2. Literature review
2.1. Supply-side determinants of capital structure and hypothesis development
The main assumption of the seminal work of Modigliani and Miller (1958) is that in
the world with no market imperfections the supply of capital is unrestricted and firms
can raise the desired amount of capital at the same cost of capital. This implies that
the amount of debt in the capital structure is determined by the demand-side factors
only. This was the underlying assumption of the most of the previous literature, which
concentrated largely on the demand-side characteristics, while paying little attention
to the supply-side factors. For example, Rajan and Zingales (1995) in their cross-sec-
tional study of the determinants of capital structure choice across G-7 countries con-
centrate on the four factors of capital structure: size (measured by sales), profitability,
asset tangibility, and market-to-book ratio. They justify their choice by stating that pre-
vious studies have shown consistent correlation of these four factors with leverage
(for example, Harris and Raviv 1991). However, they also mention that limitations on
data availability restricted their ability to develop proxies for other determinants,
implying that there might be other factors that determine corporate capital structure.
Frank and Goyal (2007) suggest that Rajan and Zingales (1995) omit two crucial varia-
bles in their model—the effect of expected inflation and median industry leverage.
They add these two factors to those four used by Rajan and Zingales (1995). Frank
and Goyal (2007) refer to these six factors as ‘core factors’ that explain variation in
capital structure and describe the model including these factors as the ‘core model’.
The above arguments fail to recognise the possibility that the supply of debt capital
can be restricted and firms might not always raise the desired amount of debt due to
both cost of debt and its availability. Market frictions such as information asymmetry
can impact a firm’s ability to raise finance such that debt funds are rationed by lend-
ers. Informationally opaque firms are likely to be credit constrained. As banks have
structures in place to determine which of these firms are creditworthy, these types of
firms are more likely to borrow from banks. Theory predicts that an opaque firm is
very likely to be credit constrained (Stiglitz and Weiss 1981). Banks tend to have the
expertise and therefore an advantage at collecting information to evaluate the credit
risk of opaque firms. It follows then that opaque firms are more likely to borrow from
banks. However, these funds are likely to be a more expensive source of debt capital
than that available from the public debt markets. The higher cost of bank debt is likely
due to the expenses incurred in the monitoring of opaque borrowers. Furthermore, if
the monitoring and additional scrutiny performed by a bank cannot completely elim-
inate the information asymmetry, then bank credit still may be rationed. As it is not
always the case that a firm can source debt funds from both bank and public debt
markets we could have a situation where a firm is debt capital constrained. So it fol-
lows that if credit markets are tight such that firms cannot raise the amount of bank
debt they desire (some loan applications are rejected), and these firms don’t have
access to the public debt markets we should see this manifest itself by way of lower
leverage ratios for these bank debt constrained firms. It follows then that a firm’s cap-
ital structure (leverage ratio) could be related to a firm’s ability to access public debt
markets. In this paper, we investigate this potential link.
The importance of the supply of debt has been acknowledged in recent years with
several researchers recognising that information asymmetry can impact the firms’ abil-
ity to raise finance. Faulkender and Petersen (2006) show that firms with access to
capital markets are able to borrow more and at lower rates of interest, whereas, firms
without access can be significantly under-levered. As a result, firms with access to
public debt markets have higher leverage ratios relative to those that do not have
such access. Leary (2009) also argues that firms with limited access to non-bank capital
can be financially constrained. He finds that larger firms with access to capital market
have a greater ability to substitute towards arm’s length financing. As a result, these
firms were less affected by a contraction in bank loan supply during the 1966 Credit
Crunch in the United States than firms without access. Leary (2009) shows that follow-
ing the 1966 Credit Crunch the use of public debt by firms with access to public debt
markets increased, relative to that of small, bank-dependent firms. As a consequence,
the leverage of bank-dependent firms significantly declined compared to firms with

access to public bond markets.
It follows that market inefficiencies can influence firms’ ability to borrow and their
desired level of leverage can differ from what they can obtain. Thus firms with limited
access to additional sources of debt capital that fail to obtain their desired level of
leverage are likely to be under-levered (Faulkender and Petersen 2006). A credit rating
by providing firms with access to public debt market helps to reduce information
asymmetry between issuers and outside investors thereby widening the potential
investors’ base for rated firms. As a result firms with a rating face fewer financial con-
straints and are able to borrow more, which could be especially important during peri-
ods when credit conditions are tight. Faulkender and Petersen (2006), Mittoo and
Zhang (2008), Kisgen (2009) find that firms with a rating can access public debt mar-
ket, and consequently have higher leverage ratios than those without a rating. It fol-
lows that since a credit rating facilitates access to additional sources of debt finance
over and above those sources available to all firms such as bank and non-bank private
debt, companies with a rating should be able to raise more debt capital than compa-
nies without one.
With access to public debt markets and consequently credit ratings being a poten-
tially important driver for firms financing decisions it is surprising that only a relatively
small but growing number of papers have examined the relationship between credit
ratings and capital structure decisions. Given the widespread use of credit ratings in
the US, largely due to the Security and Exchange Commission (SEC thereafter) regula-
tory requirements, the overwhelming majority of the studies that have investigated
the effect of credit ratings on capital structure employ US data. In the UK credit rat-
ings have gained significant importance in recent years and the need for having a
credit rating in the UK has been recognized by many corporates during the
2007–2009 financial crisis as a means to access alternative sources of finance (Bacon,
Grout, and O’Donovan 2009).
2.2. Overview of the empirical literature examining the link between capital
structure and credit ratings
A credit rating represents an opinion made by one of the major credit rating agencies
(Standard and Poor’s (S&P thereafter), Moody’s Investor Service or Fitch IBCA) of gen-
eral creditworthiness of either an issuer (individual, corporation or country) or a par-
ticular issue (a loan) (Eades and Benedict 2006). It provides information about the
credit quality of a firm and hence broadens the scope of potential investors for rated
companies, such as pension funds, hedge funds and mutual funds thereby increasing
the supply of debt capital (Faulkender and Petersen 2006; Kisgen 2007; Leary 2009).
Unlike most of the prior literature which focus mainly on the demand-side determi-
nants of debt, a few recent studies have demonstrated that access to public debt mar-
kets measured by the possession of a credit rating play an important role in
determining corporate capital structure is an important determinant of capital struc-
ture (Faulkender and Petersen 2006; Kisgen 2006; Mittoo and Zhang 2008; Leary
(2009). However, as Kisgen (2007) indicates, neither the trade-off nor the pecking order
theories explicitly take the possession of a credit rating into account. Boot, Milbourn,
and Schmeits (2004) argue that credit ratings ‘play an economically meaningful role’
(Boot, Milbourn, and Schmeits 2004, 1). They point out that according to Standard and
Poor’s document (in Dallas, 1997) ‘ratings often provide the issuers with an “entry”
ticket into public debt markets, broadening the issuers’ financing opportunities’ (Boot,
Milbourn, and Schmeits 2004, 3). Thus they argue that ‘credit ratings could act as
“information equalizer” thereby enlarging the investor base’ (Boot, Milbourn, and
Schmeits 2004, 3).
Rating agencies assign ratings by evaluating company’s information that is not pub-
licly available (Kisgen 2007). Eades and Benedict (2006) indicate that such agencies
operate without any government mandate, and their opinions are independent from
the investment community. A credit rating therefore helps to reduce information
asymmetry between issuers and outside investors through the disclosure of new infor-
mation and thereby facilitate a firm’s credit market access (Tang 2009). Tang (2009)
mentions that without certification from Credit Rating Agencies (CRAs thereafter) firms
may be unable to borrow from public debt markets. Furthermore, by reducing infor-
mation asymmetry a credit rating can increase firm value. An and Chan (2008) in their
study of the relationship between credit rating and IPO pricing document that firms
without a credit rating can still go public by obtaining a loan issue rating only.
However, according to An and Chan (2008) they will be underpriced more than firms
with a credit rating.
The quality of the assigned rating may also be relevant. Kisgen (2007) suggests that
having a good credit rating is important because regulations for both pension and
mutual funds require limiting their investments in low-rated bonds (which are defined
as having a rating A or less) (Kisgen 2007, 67). He argues that maintaining a particular
credit rating level provides benefits to a firm, such as ‘the ability to issue commercial
paper, access to investors otherwise restricted from investing in the firm’s bonds,
lower disclosure requirements, reduced investor capital reserve requirements,
improved third-party relationships, and access to interest rate swap or Eurobond mar-
kets’ (Kisgen 2007, 65). As a result companies in order to obtain the required financ-
ing, ‘target’ a particular rating and try to maintain it over time (Kisgen 2007). Kisgen
(2007) suggests that during adverse economic conditions obtaining financing becomes
especially difficult for firms without an investment grade rating and they may have to
forgo positive-NPV projects.
Graham and Harvey (2001) survey 392 CFOs in the US about the cost of capital,
capital budgeting, and capital structure. They find that CFOs consider credit rating to
be the second important debt factor following financial flexibility (57% of CFOs ranked
credit rating as important or very important with mean of 2.46). Credit rating is espe-
cially important for large firms (mean of 3.14). Thus, Graham and Harvey (2001) find
financial flexibility and credit ratings to be the most important debt policy factors.
Bancel and Mittoo (2004) conducted a similar survey to that of Graham and Harvey
(2001) that spanned 16 European countries although their sample was smaller than
that of Graham and Harvey (2001) (only 87 respondents compared to 392 respondents
in the US survey). They find that a credit rating and target debt ratios are important
issues for managers in firms across 16 European countries. Consistent with Graham
and Harvey (2001) their research shows that credit rating is ranked as the second
most important determinant of debt after financial flexibility (73% of managers con-
sider credit rating important or very important). By comparing managers’ responses
from the US with European ones, they find that a credit rating is considered to be
more important by European rather than US managers (73% of the European manag-
ers consider credit rating to be important or very important versus to 57% of the
US managers).
Faulkender and Petersen (2006) argue that a credit rating provides access to the
public debt market and thus reduces dependence on local banks. Using a large panel
dataset they find that firms which have access to the public bond market as proxied
by having a debt rating have 6 to 8 percent more leverage even after controlling for
firm characteristics that determine observed capital structure.
Sufi (2009) examines the effect of the introduction of syndicated bank loan ratings
(a loan made to a firm jointly by more than one financial institution) on company’s
financial and investment policy. A loan rating is given to a specific tranche of borrow-
ing tied to a particular project rather than to the company as a whole. This study finds
evidence that firms that obtain a loan rating experience an increase in the supply of
available debt financing, an increase in their equilibrium use of debt, and a permanent
increase in their leverage ratio. In particular, Sufi (2009) shows evidence that loan rat-
ings allow borrowers to expand the set of creditors beyond domestic commercial
banks toward less informed investors such as foreign banks and non-bank institutional
investors. The results are significantly stronger in magnitude among firms that are of
lower credit quality and do not have an existing public bond rating before the intro-
duction of loan ratings. For instance, unrated firms that obtain a loan rating experi-
ence an increase in their leverage ratio by 0.11 more than rated firms that obtain a
loan rating, which is more than 40% at the mean. These results suggest that loan rat-
ings increase the supply of available debt financing. Although it seems that loan rat-
ings increase the supply of available debt financing the affect on information
asymmetry may not be as great as that caused by having a credit rating. An and Chan
(2008) in their study of the relationship between credit rating and IPO pricing docu-
ment that firms without a credit rating can still go public by obtaining a loan issue
rating only. However, according to An and Chan (2008) they will be underpriced more
than firms with a credit rating. Thus by reducing information asymmetry by a greater
amount a credit rating can increase firm value.
Kisgen (2006) and Kisgen (2007) consider the effect of credit rating changes on
firms leverage levels before and after a credit rating up- or downgrade, respectively.
Unlike Faulkender and Petersen (2006), both Kisgen’s (2006) and (2007) samples only
include firms with a credit rating. Kisgen (2006) finds that firms near either a credit rat-
ing upgrade or downgrade issue less debt relative to equity than firms not near a
change in rating. His results indicate that firms near a ratings change issue approxi-
mately 1.0% less net debt relative to net equity annually than firms not near a ratings
change. Kisgen (2007) finds that firms reduce leverage following credit rating down-
grades, whereas, rating upgrades do not affect subsequent capital structure activity,
suggesting that firms target minimum rating levels. Firms that have been downgraded
issue over 2.0% less net debt as a percentage of assets relative to equity the
subsequent year than firms that have not been downgraded. Kisgen (2007) finds the
results of both papers to be complementary, since both papers find that it is consist-
ent for firms to try to avoid/reverse downgrades and achieve upgrades. Tang (2009)
examines Moody’s credit rating format refinement in 1982 to study the effects of infor-
mation asymmetry on firms’ credit market access, financing decisions, and investment
policies. Tang (2009) finds that a refinement rating upgrade leads to a 20 basis points
reduction in firms’ borrowing costs over a refinement downgrade. He also finds that a
higher refined rating allows firms to issue significantly more long-term debt than a
lower refined rating in the one-year period subsequent to the rating refinement: a rat-
ing refinement upgrade leads to a 2% increase in firms’ subsequent long-term debt
issuance over its previous debt issuance, relative to a rating downgrade. More recently,
Kemper and Rao (2013a, 2013b) have also looked at the effect of credit rating changes
and argue that Kisgen’s (2006) results don’t hold for all financial circumstances. They
find that only firms with a very low rating, such as B or below, consider credit ratings
when determining their capital structure. Their findings also suggest that credit ratings
do not seem to influence leverage decisions in firms that issue short-term debt such
as commercial paper, that have investment opportunities, or make use of the debt
capital markets. Furthermore, Kemper and Rao (2013a, 2013b) suggest that rating
changes are less likely to impact capital structure when firms have other means to
manage their ratings levels, such as restructuring assets or lowering operating costs.
Several studies examine the relation between the level of a credit rating and a
firm’s capital structure. In this respect, Hovakimian, Kayhan, and Titman (2009) exam-
ine how firms target their credit ratings. They find that below-target firms tend to
make financing, payout, and acquisition choices that decrease their leverage whereas
above-target firms tend to make choices that increase their leverage. They also find
these reactions to be asymmetric with firms reacting stronger when their rating is
below the target than when the rating is above the target. Furthermore Hovakimian,
Kayhan, and Titman (2009) show that since a high rating requires a firm to include a
substantial amount of equity in its capital structure (which can be very costly), high
credit ratings are observed only for firms that are likely to benefit the most from a
higher credit rating, e.g. growth firms that expect to be raising substantial capital in
the future. In contrast, smaller firms may require proportionally more equity in their
capital structures to achieve the same rating, which may be costly; hence, small firms
tend to have lower ratings. Mittoo and Zhang (2010) find that speculative grade firms
have leverage ratios around nine percent higher than their investment grade counter-
parts for a sample of Canadian and US firms. These findings are consistent with the
idea that investment grade firms maintain lower leverage levels because they are con-
cerned about downgrades, while speculative grade firms increase their leverage to
improve their financial flexibility. In the latter case, speculative grade debt can be an
important source of financing for high growth firms, which can help to prevent the
impact of adverse economic conditions and credit rationing. Similarly, Wojewodzki,
Winnie, and Shen (2018) show that the credit rating level is negatively associated with
leverage and that firms with a low rating adjust their capital structure faster than firms
with a high credit rating. The role of financial flexibility also plays a role in Byoun’s
(2011) study. He finds an inverted-U relationship between leverage and having a credit
rating. Small firms with no credit ratings have lower leverage ratios since they issue
much more equity than debt to ease their lack of financial flexibility, medium growing
firms with credit ratings have high leverage ratios by issuing debt against large future
expected cash flows, while large mature firms with good credit ratings have moderate
leverage ratios as they rely on internal funds and use only safe debt in order to pre-
serve financial flexibility. He considers these findings to be important since previous
studies overlooked the roles of these variables and their non-linear relationship with
the leverage ratio.
Some recent studies have examined whether there is an asymmetric effect on cap-
ital structure resulting from a rating change. Maung and Chowdhury (2014) investigate
the time it takes firms to adjust their capital structure when either an upgrade or
downgrade of a credit rating occurs. They find that a rating change induces an adjust-
ment in the leverage ratio, however, in the case of a rating downgrade the change in
leverage takes place over a longer time period and is persistently significant compared
to a rating upgrade. Similarly, Huang and Shen (2015) find that a sample of global
firms adjust their capital structure when ratings are downgraded, but they do not sig-
nificantly adjust the capital structure when ratings are upgraded. In related research,
Samaniego-Medina and di Pietro (2019) examine the effect of the plus or minus signs
of a credit rating on the speed of leverage adjustment within a European context and
include the 2007–2009 financial crisis years in their sample period. Their results con-
firm that companies with signs in their ratings slow their speed of adjustment to the
target leverage ratio. In particular, when a rating is accompanied by a minus sign, a
firm adjusts more slowly than firms either with a plus sign or without a sign. When
the rating has a plus sign, the firm’s leverage adjustment is slower than when the rat-
ing has no sign. If a firm is close to losing its investment grade status they find the
speed of leverage adjustment is close to zero.
The majority of the extant research employs US data. However, the factors driving
the capital structure decisions of European corporates might differ significantly com-
pared to those of US firms and across countries in Europe, especially since the legal
systems, bankruptcy codes, corporate governance rules and tax regimes vary consider-
ably across Europe all of which may influence firm financing decisions (see, for
example, Antoniou et al. 2008; Rajan and Zingales 1995).
3. Sample, data and empirical analysis

3.1. Sample and data description
Our sample utilises data for the top 500 of UK listed non-financial firms by market cap-
italization for the period 1989 through to 2010. All financial firms are excluded from
the analysis, resulting in a panel of 7,828 firm-year observations. All firms with zero
debt (785 firms) are also dropped from the sample, resulting in a panel of 7,043 firm-
year observations. This is done in order to avoid a misclassification bias caused by the
assumption that these firms do not have debt because they do not qualify to have a
rating. These firms might qualify for a rating but choose equity as a preferred source
of finance (Faulkender and Petersen 2006; Chava and Purnanandam 2011).
We obtain credit rating data directly from Standard and Poor’s (S&P) and Fitch
credit rating agencies. We use a company’s long-term credit rating to proxy for access
to the public debt markets. We use a credit rating dummy variable set equal to one if
a firm possesses a rating (S&P and/or Fitch) in a particular year and zero otherwise.
Credit rating data from S&P covers the 22 years from 1989 to 2010 and Fitch credit rat-
ing data covers 20 years from 1989 to 2008. We merge the two sets of data and use a
firm’s S&P rating in cases where it has two ratings. Overall, 1,373 (17.5%) of firms in
our sample have a rating (S&P and/or Fitch).
Data on leverage and other the firm-level characteristics is sourced from
DataStream. Leverage is measured as a ratio of total debt over either market or book
value of assets. Total debt includes short-term and long-term debt. It reflects the pro-
portion of debt in the firm’s total assets. A full list of variables, their definitions and
predicted relationship with leverage are reported in Appendix 1. All variables that con-
tain firm-level data are winzorised at the 1% level. This minimises the chance of out-
liers having an effect on the results.
We include two variables that measure macroeconomic conditions. These are
annual GDP growth rate, which intends to control for the economic conditions in the
country and stock market return, proxied by the FTSE All-Share Index.
Figure 1 shows the frequency (left hand side) and the proportion (right hand side)
of rated firms with S&P and/or Fitch ratings over the 22 year period from 1998 to
2010. The number of rated firms in our sample increases steadily from 1989 to 2000
and then starts to fall, due in part to mergers between rated firms, stock market de-
listings and firms ceasing to possess a rating. This could also be due to the fact that
Fitch ratings data is only available up to the year 2008.
3.2. Empirical analysis

In this study we utilise data for the period 1989 through to 2010. We employ both
univariate and multivariate techniques in our empirical analysis. First of all, univariate
independent sample t-test analysis compares leverage and other financial characteris-
tics of firms with and without access proxied by having a credit rating. Multivariate
regression analysis presents empirical results on whether the possession of a credit
rating (i.e. access to public bond markets) can explain variation in leverage ratios,
holding other things constant.
In our analysis we employ firm size as an alternative measure of access to debt cap-
ital markets. According to Leary (2009) size is highly correlated with bond market
access and therefore can help to verify the robustness of our results. Similar to Leary
(2009) we use book value of assets to generate proxies for bond market access based
on firm size. We sort the firm-year observations by book value of assets and create
three separate size dummies. In our first measure, firms in the top 30% of the distribu-
tion are classified as having access, whereas the remaining 70% of firms are consid-
ered as not having access. In our second measure, firms in the top 30% of the
distribution are classified as having access, and firms in the bottom 30% are classified
as not having access. In the last measure, firms with a rating are classified as having
access, and firms in the bottom 30% are considered as not having access.
Figure 1. Number of Rated UK firms from 1989 to 2010. Source: S&P Ratings Direct and
Fitch Ratings
It is important to note that in the second and the third measures we have to drop
a considerable number of observations. In our second measure we keep the top and
bottom 30% for the firm size distribution and drop the middle 40% of firms. For the
third measure we include all rated firms and those in the bottom 30% of the firm size
distribution.
3.2.1. Differences in leverage ratios and other firm characteristics between rated
and non-rated firms
In this section, we conduct univariate independent sample t-tests to verify whether
leverage and other firm-level data differs between firms with and without public bond
market access. Firm characteristics include size, age, profitability, asset tangibility,
growth opportunities, business risk, tax shields—which are predicted to be related to
firm’s indebtedness. Here we test whether these characteristics are also related to a
firm’s ability to access capital markets. Table 1 reports differences in mean and median
values of firm leverage and other firm-level financial characteristics between firms with
and without access.
Panel A of Table 1 shows that firms with a rating have significantly more leverage
in their capital structure than firms without a rating. The results are similar whether
we measure leverage by market or book value of assets. The univariate t-test shows
that companies with rating have on average 7% more market leverage and 9% more
book leverage. When we measure access by size the percentage difference is even
higher: almost 9% in Panel B1; 15% in Panel B2; and 14% in Panel B3.
Firms with a rating are also noticeably larger than firms without one, which is con-
sistent with Faulkender and Petersen (2006) who suggested that only large firms issue
public debt due to higher fixed costs associated with issuing bonds. Firms with rating
appear to be 33% older (both mean and median differences are statistically significant)
Table 1. Differences in leverage and other firm characteristics between firms with access (A) and
without access (NA).
Mean difference Mean Test Median Test
Rated N Non-rated N (A  NA) A vs. NA A vs. NA
(1) (2) (3) (4) (5) (6) (7)
Panel A: Access is measured by credit rating
Market leverage 0.2763 1367 0.2014 6321 0.0749 A > NA A > NA
Book leverage 0.2993 1316 0.2074 5996 0.0919 A > NA A > NA
Size 15.4343 1367 12.7424 6348 2.6919 A > NA A > NA
Age 3.5515 1367 3.2215 6435 0.3300 A > NA A > NA
Asset tangibility 0.6604 1324 0.5214 5970 0.1391 A > NA A > NA
R&D spending 0.0438 1299 0.0162 5881 0.0276 A < NA A > NA
Market-to-book 0.1332 1316 0.2396 5986 0.1065 A < NA A < NA
Profitability 0.1203 1343 0.0941 6224 0.0261 A > NA A > NA
Asset volatility 0.2168 1345 0.2636 6046 0.0468 A < NA A < NA
Equity return 0.0311 1359 0.0225 6109 0.0086 A > NA A < NA
Short-term debt 0.2475 1311 0.3673 5601 0.1198 A < NA A < NA
Tax paid 0.2563 1317 0.2453 5991 0.0110 A > NA A < NA
Access N No access N Mean difference A vs. NA Median test
Panel B:
1. Access is measured by size (Top 30% vs. Remaining 70% of firms by the size distribution)
Access N No access N Mean difference A vs. NA Median test
2. Access is measured by size (Top 30% vs. Bottom 30% of firms by the size distribution)
Book leverage 0.2779 1808 0.1442 1804 0.1337  A > NA A > NA
Access N No access N Mean difference R vs. NR Median test
3. Access is measured by Rated vs. Bottom 30% of Firms by the size distribution
The table reports the results from univariate independent sample t-tests for the sample of UK listed non-financial
firms with and without the public debt access for the period from 1989–2010 and contains firm-year observations
with positive debt only. Access to debt market is measured by: (1) the possession of long-term corporate credit rat-
ing (Panel A); (2) Firm size based on the Top 30% and the Remaining70% of firms by the size distribution (Panel
B1); (3) Firm size based on the Top 30% and the Bottom 30% of firms by the size distribution (Panel B2); (4) the
possession of credit rating and firms in the bottom 30% of firms by the size distribution (Panel B3). Mean values are
reported. The fifth column reports mean differences between firms with and without access. The last column (7)
reports median test for the differences between firms with and without access. A—Access; NA—No Access.
 indicates statistical significance at 1% level, 5% level, 10% level.
and more profitable; possess on average 14% more tangible assets (the mean and
median differences are statistically significant), but spend less on research and devel-
opment and have lower growth opportunities as measured by the market-to-book
ratio. Rated firms have lower risk, measured by asset volatility and have higher equity
returns. Firms with a rating have 12% less short-term debt, which is consistent with
the notion that public debt is likely to have longer maturity periods (Faulkender and
Petersen 2006). Average tax rates ratios, proxy for marginal tax rates, are expected to
be higher for the rated firms because of the higher tax shields effect. We have some
evidence in support of this. In Panel A the difference is positive but insignificant.
However, in unreported analysis, when access is measured by firm size, the difference
becomes statistically significant.1 In this section we have verified that firm-level factors
are different for firms with and without access. It is thus essential to control for these
factors in order to separate the effect of having a rating (access) on leverage in our
multivariate regression.
Table B.1 reports a pairwise correlation matrix of the variables used in our analysis.
It is apparent from this table that all the correlation values between variables are well
below 0.7, in fact the highest correlation between the independent variables is 0.37
suggesting relatively weak levels of correlation. It follows that our multivariate estima-
tions are not likely to have a multicollinearity problem.
3.2.2. Multivariate analysis

In the second stage of our empirical analysis we test whether the possession of a
credit rating (access to public bond market) has an impact on firm’s leverage in a
multivariate setting by estimating Eq. (1):
Leverageit ¼ a0 þ a1 CreditRating þ b1 Xit þ b2 GDPt þ b3 FTSEALLSHt þ b4 IDi þ eit (1)
Leverage is measured by the debt-to-asset ratio;

CreditRating measures a firm’s access to public debt markets;
Xit is a vector of firm-specific control variables that measure firm’s demand for debt
(firm size, age of firm, profitability, asset tangibility, debt maturity, market-to-book
ratio, R&D spending, asset volatility, equity return, debt tax shield). This allows us to
measure the effect of having a rating on leverage ratios while holding other fac-
tors constant.
IDi—is a vector of industry-specific control variables;
GDP and FTALLSH—macroeconomic control variables.
The coefficient of our interest is a1 which measures the change in leverage due to
the possession of a credit rating. We estimate Eq. (1) using first, pooled OLS regression
with clustered standard errors by firms to control for the residual correlation across
years for a given firm.
One of the major concerns with the pooled OLS estimation technique is the omitted
variable problem. It is possible that the estimates of coefficients derived from the OLS
regression may be subject to omitted variable bias. To mitigate the omitted variable prob-
lem we can use panel regression estimation methods, such as random effects or fixed
effects techniques. If the omitted variables are uncorrelated with the explanatory variables
in the model then a random effects model is the most appropriate technique. However, if
the omitted variables are correlated with the variables in the model, then a fixed effects
estimation will most likely provide the best means for controlling for omitted variable bias.
In our setting, it is possible that there is an unobserved explanatory variable, which cannot
be controlled for, that affects the dependent variable. This suggests a fixed effects estima-
tion. This technique is also more appropriate when there is a relatively small cross-section
and a lengthy time-period, which fits the characteristics of our panel dataset.2
In all models leverage is regressed on a set of firm characteristics to control for
firm’s demand-side factors and a proxy for bond market access (credit rating dummy)
to control for the supply of debt. Leverage is measured as a ratio of gross total debt
to market value of assets. Bond market access is proxied by a possession of a credit
rating. Firm characteristics include factors most commonly used in the capital structure
literature: firm size, firm age, asset tangibility, profitability, market-to-book ratio, and
spending on R&D. We also include asset volatility and firm’s equity return as two add-
itional control variables. Faulkender and Petersen (2006) suggest that maturity of debt
is positively associated with leverage, since public debt tends to be of longer matur-
ities. Following Faulkender and Petersen (2006) we incorporate the portion of short-
term debt to control for debt maturity. In our analysis we also control for debt tax
shield effects. We estimate our specifications with and without firm size. Table 2
presents results from pooled OLS with cluster standard errors and panel estimation
techniques from Eq. (1).
The key variable of interest in our analysis is the credit rating dummy. The results
in Table 2 show that the coefficient on the credit rating dummy is positive and highly
statistically significant across all specifications. After controlling for firms’ demand for
debt we find strong evidence that firms with a rating have between 3% (OLS results)
and 4.6% (Panel results) higher leverage ratios compared to their unrated counter-
parts.3 Our coefficient is lower than the 8% reported by Faulkender and Petersen
(2006) for US firms and 6% found by Mittoo and Zhang (2008) for Canadian firms, but
is slightly higher than Leary’s (2009) coefficient on predicted probability of having a
bond rating 2.8% (Leary 2009: 1179).
The coefficients on the firm characteristics are generally consistent with the extant
literature, except for the coefficient on the size variable, which is negative. Faulkender
and Petersen (2006) and Leary (2009) also find a negative relationship between size
and leverage. Faulkender and Petersen (2006) suggest that this could be explained by
the positive correlation between size and credit rating and by using total debt-to-asset
ratio, whereas some of the previous papers use long-term debt to assets. Similar to
Faulkender and Petersen (2006) we use total debt-to-asset ratio as a measure of a
firm’s leverage. Leary (2009) also find’s a negative coefficient on size when he uses the
predicted rating probability to proxy for bond market access. We replicate models (1),
(2) and (3) without size.
We find strong evidence that age and leverage are positively related. Faulkender
and Petersen (2006), however, find strong negative relationship between age and
leverage in their study. We find a negative relationship between leverage ratios and
profitability as measured by return on invested capital. This is consistent with the
notion that more profitable firms rely less on external funding and use retained earn-
ings for financing purposes. Tangible assets can serve as collateral when raising debt
and therefore firms with more tangible assets are likely to have higher leverage ratios.
Our results mirror previous studies in that we provide strong evidence that tangible
assets are positively related to leverage across all specifications. We find some evi-
dence that firm’s leverage ratios and market-to-book ratio are inversely related, how-
ever, our coefficient on R&D spending is not significant.
We measure riskiness of operations by asset volatility, which is calculated by multiply-
ing standard deviation of daily equity return by the equity-to-asset ratio. Firms with more
volatile assets are expected to have higher probabilities of default, and therefore, lower
leverage ratios. As predicted the coefficient on asset volatility is negative and highly statis-
tically significant (p < 0.01). Following Faulkender and Petersen (2006) equity return over
Table 2. The impact of bond market access (measured by credit rating) on leverage: Pooled OLS
and panel estimation methods.
(1) (2) (3) (4) (5) (6)
Variables OLS FE RE OLS FE RE
Credit rating 0.0343 0.0432 0.0462 0.0307 0.0400 0.0416

(0.013) (0.017) (0.015) (0.011) (0.017) (0.014)
Size 0.0017 0.0152 0.0054
(0.004) (0.005) (0.004)
Age 0.0107 0.0763 0.0358 0.0103 0.0590 0.0322
(0.005) (0.012) (0.006) (0.005) (0.011) (0.006)
Profitability 0.2165 0.1864 0.1888 0.2179 0.1898 0.1907
(0.018) (0.017) (0.016) (0.017) (0.017) (0.016)
Asset tangibility 0.0974 0.1174 0.1156 0.0951 0.0930 0.1066
(0.024) (0.026) (0.021) (0.024) (0.025) (0.020)
R&D Expenditure 0.0047 0.0030 0.0019 0.0051 0.0038 0.0024
(0.004) (0.004) (0.004) (0.004) (0.004) (0.004)
Market-to-book 0.0143 0.0013 0.0056 0.0145 0.0045 0.0066
(0.002) (0.003) (0.002) (0.002) (0.002) (0.002)
Equity return 0.1040 0.1040 0.1029 0.1046 0.1063 0.1040
(0.006) (0.005) (0.005) (0.006) (0.005) (0.005)
Asset volatility 0.3798 0.2812 0.2960 0.3795 0.2862 0.2977
(0.029) (0.023) (0.022) (0.029) (0.024) (0.022)
Short-term debt 0.0890 0.0582 0.0642 0.0876 0.0524 0.0615
(0.011) (0.011) (0.010) (0.011) (0.011) (0.010)
Tax paid 0.0367 0.0199 0.0220 0.0372 0.0213 0.0226
(0.009) (0.006) (0.006) (0.009) (0.006) (0.006)
Market return 0.0529 0.0469 0.0515 0.0521 0.0461 0.0507
(0.011) (0.009) (0.009) (0.011) (0.009) (0.009)
GDP growth 0.0120 0.0126 0.0130 0.0121 0.0134 0.0132
(0.001) (0.001) (0.001) (0.001) (0.001) (0.001)
Constant 0.3375 0.2533 0.2372 0.3170 0.1298 0.1829
(0.046) (0.056) (0.047) (0.025) (0.038) (0.027)
Observations 6,479 6,479 6,479 6,480 6,480 6,480
R-squared 0.4868 0.3902 0.4867 0.3861
F test 68.0108 82.2034 70.3357 88.1287
Prob > F 0.0000 0.0000 0.0000 0.0000
Number of firmid 475 475 475 475
Chi2 test 1501.9098 1490.8588
Prob > Chi2 0.0000 0.0000
The table presents estimates of Eq. (1) using annual data of UK listed non-financial firms for the period from 1989
to 2010. Columns 1 and 4 report results from pooled OLS, columns 2 and 5 report results from fixed effects and col-
umns 3 and 6 report results from random effects. The dependent variable is the ratio of total debt to the market
value (MV) of assets. Total debt incorporates short-term debt and long-term debt. MV of assets is the sum of MV of
equity and BV of total debt. Public bond market access is proxied by the possession of a long-term corporate credit
rating. All variables are winzorised at 1% level in order to prevent potential outliers driving the results. All specifica-
tions include annual stock market return and annual GDP growth rate to control for macroeconomic conditions.
Annual stock market return is calculated as natural logarithm of FTSE at the end of the year over FTSE at the begin-
ning of the year. Annual GDP growth rate is sourced from the IMF official website. Industry dummies are included
across all specifications to control for industry-specific effects. Variables definitions are presented in Appendix 1.
Standard errors (in parenthesis) are adjusted for heteroskedasticity and clustering by firms.
, ,  indicate statistical significance at 1%, 5%, and 10% levels respectively.
the previous year is included to account for partial adjustment in the firm’s capital struc-
ture. They argue that following an increase (decrease) in its equity value a firm should
make a corresponding adjustment of debt in order to maintain its debt-to-asset ratio,
otherwise the firm will de-lever. The coefficient on equity return is negative and statistic-
ally significant across all six specifications (p < 0.01), indicating that an increase in firm’s
equity over the past year lowers its leverage ratio.
Faulkender and Petersen (2006) suggest that rated firms issue bonds that tend to
have longer maturities than private debt. Unrated firms, on the other hand, find it dif-
ficult to access public markets and are more likely to raise short term financing from
private investors such as banks. To examine this we include the fraction of short-term
debt that is due in one year including current portion of long-term debt due within
one year. Consistent with our a priori expectation, the coefficient on short-term debt
is negative and highly statistically significant.
One of the benefits of debt for firms is the tax shield effect. Firms with higher mar-
ginal tax rates should have higher interest tax shields, and therefore should be more
leveraged. We use average tax rates to proxy for marginal tax rates. Contrary to the pre-
diction, the coefficient on tax paid is negative and statistically significant. Faulkender and
Petersen (2006) also find negative and significant coefficient on their marginal tax rate.
Similar to Leary (2009), in addition to the firm-specific variables that control for firms’
demand for debt, we include macroeconomic variables that control for time-specific con-
ditions that can influence the capital structure decision of a firm. Following Leary (2009)
we include two proxies for macroeconomic conditions in all our models: annual GDP
growth rate and annual stock market return.4 The coefficient on our annual stock market
return variable is negative and statistically significant in all specifications. Consistent with
the market timing theory this indicates that following favorable stock market conditions
firms issue less debt and more equity. According to Huang and Ritter (2004) who test
the market timing theory of capital structure, firms issue equity when the relative cost of
equity is low, and issue debt otherwise. The coefficient on annual growth in GDP is also
negative and significant, which is in line with the arguments presented for favourable
stock market conditions. Leary’s (2009) coefficients on macroeconomic variables vary in
signs. In summary our key finding is that firms with access as measured by a possession
of credit rating have higher leverage ratios compared to their unrated counterparts.
3.2.3. Robustness tests: alternative measures of access

To verify that our results are not driven by the way we measure access (credit rating) and are
robust to using alternative measures of public debt market access, we re-estimate Eq. (1) using
three additional measures of access based on the book value of assets distribution:
1. Top30%–Remaining70%
2. Top30%–Bottom30%
3. Rated—30%Small
Table 3 presents results from both Pooled OLS and Panel estimation techniques.
In Table 3 the key variable of interest is access measured by the firm size dummy.
Following Leary (2009) we do not include a variable proxying for firm size in these
specifications due to high correlation between our proxy for access and firm size:
 Correlation between size and Top30%–Remaining70% ¼ 0.66

 Correlation between size and Top30%–Bottom30% ¼ 0.85
 Correlation between size and Rated—Small30% ¼ 0.85
The results from Table 3 are generally consistent with the results in Table 2.
Whether we measure access by the possession of a credit rating or firm size, firms
with bond market access have higher leverage ratios. When we measure access by
Top30%–Remaining70% (columns 1–3) we find that firms with access have about 2%
more leverage (OLS and RE). When we measure access by Top30%–Bottom30% (col-
umns 4–6) we find that firms with access have between 2–4% more leverage (OLS
and RE). When the possession of a credit rating is benchmarked against the smallest
30% of firms in our sample we find that the leverage difference between firms with
and without access is greater (firms with access have between 6–7% more leverage),
suggesting that firms without access are more credit constrained than firms with
access. Coefficients on the demand-side characteristics coefficients are consistent with
the results in Table 2.
4. Addressing endogeneity
4.1. Instrumental variable method
In our study, we control for the possible endogeneity of the firms’ decision to possess
a credit rating. Endogeneity arises when credit rating is correlated with the error term,
thereby violating the exogeneity assumption. As a result OLS estimates can be biased
and inconsistent. If there is a firm-level factor that affects a firm’s decision of possess-
ing a credit rating and also determines its leverage that we do not observe, then our
coefficients from OLS and panel regressions can be biased. To control for the potential
endogeneity we first use 2SLS instrumental variables (IV) estimation.5 We use two
methods to estimate our model using instrumental variable approach. In the first
method we use a probit specification in the first stage to estimate the probability of
possessing a credit rating.6 In the second stage we use the predicted probability for
possessing a credit rating from the first stage probit regressions to estimate the
impact of having a rating on firm’s leverage.7 Bascle (2008) however suggests that
researchers should refrain from using a probit or logit method when the endogenous
variable is binary and use a linear regression instead. He argues that this method will
give consistent estimates in the second stage, whereas estimates obtained from a pro-
bit and plugged in the second stage will not be consistent unless the non-linear
model is exactly right (Bascle 2008, 217–218). In the second method we therefore esti-
mate our model using a linear regression in the first stage instead of probit and com-
pare these results to the ones obtained using a probit regression.
In both IV estimations the first stage involves regressing the endogenous variable (credit
rating dummy) on exogenous regressors (firm-level factors) plus instruments. In the context
of this work instruments are variables that are related to whether a firm has a credit rating
but are not directly related to a firm’s demand for debt (Faulkender and Petersen 2006).
We follow the literature to identify the variables that need to be included in the first stage
estimation of the determinants of having a rating. An and Chan (2008), Faulkender and
Petersen (2006) and Liu and Malatesta (2005) suggest that the possession of a rating is
likely to be related to size, profitability, growth opportunities and the tangibility of a firm’s
assets. For example, An and Chan (2008) point out that large firms are more likely than
small firms to have a credit rating due to the large fixed cost of issuing public debt and
Table 3. The impact of access (measured by Size30–Remaining70, Size30–Bottom30, Rated—Small 30%) on leverage: Pooled OLS and panel estima-
106
tion methods.
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Top30%–vs.70% Top30%–vs.70% Top30%–vs.70% Top30%–vs.30% Top30%–vs.30% Top30%–vs.30% Rated—vs.30% Rated—vs.30% Rated—vs.30%
Variables OLS FE RE OLS FE RE OLS FE RE
Top30%–Remaining70% 0.0218 0.0139 0.0177

(0.010) (0.009) (0.008)
Top30%–Bottom30% 0.0440 0.0255 0.0204
(0.014) (0.016) (0.012)
Rated—Small30% 0.0571 0.0759 0.0717
(0.016) (0.053) (0.020)
Age 0.0110 0.0650 0.0354 0.0143 0.0867 0.0477 0.0089 0.0452 0.0261
(0.005) (0.011) (0.006) (0.007) (0.016) (0.008) (0.008) (0.016) (0.008)
Profitability 0.2153 0.1892 0.1897 0.2066 0.1665 0.1705 0.1709 0.1479 0.1503
A. JUDGE AND A. KORZHENITSKAYA
(0.018) (0.017) (0.016) (0.021) (0.022) (0.021) (0.022) (0.023) (0.021)

Asset tangibility 0.0945 0.0928 0.1072 0.0879 0.0344 0.0711 0.0832 0.0350 0.0683
(0.023) (0.025) (0.020) (0.033) (0.033) (0.027) (0.029) (0.035) (0.028)
R&D expenditure 0.0049 0.0038 0.0022 0.0044 0.0009 0.0018 0.0035 0.0019 0.0018
(0.004) (0.004) (0.004) (0.006) (0.005) (0.005) (0.006) (0.006) (0.006)
Market-to-book 0.0140 0.0043 0.0064 0.0094 0.0015 0.0035 0.0104 0.0035 0.0050
(0.002) (0.002) (0.002) (0.002) (0.003) (0.002) (0.002) (0.002) (0.002)
Equity return 0.1046 0.1058 0.1035 0.1026 0.0952 0.0957 0.0977 0.0903 0.0909
(0.006) (0.005) (0.005) (0.009) (0.007) (0.007) (0.008) (0.007) (0.007)
Asset volatility 0.3770 0.2858 0.2966 0.3769 0.2755 0.2969 0.3335 0.2575 0.2719
(0.029) (0.023) (0.022) (0.039) (0.031) (0.029) (0.037) (0.032) (0.030)
Short-term debt 0.0885 0.0523 0.0622 0.0635 0.0221 0.0352 0.0756 0.0272 0.0376
(0.011) (0.011) (0.010) (0.015) (0.014) (0.013) (0.015) (0.014) (0.013)
Tax paid 0.0384 0.0215 0.0230 0.0446 0.0152 0.0178 0.0481 0.0162 0.0199
(0.009) (0.006) (0.006) (0.013) (0.010) (0.010) (0.012) (0.009) (0.009)
Market return 0.0554 0.0496 0.0544 0.0344 0.0565 0.0539 0.0169 0.0434 0.0371
(0.011) (0.009) (0.009) (0.016) (0.013) (0.013) (0.017) (0.013) (0.013)
GDP growth 0.0119 0.0131 0.0130 0.0118 0.0122 0.0122 0.0130 0.0136 0.0135
(0.001) (0.001) (0.001) (0.002) (0.001) (0.001) (0.002) (0.002) (0.002)
Constant 0.3136 0.1127 0.1747 0.2759 0.0655 0.1302 0.2867 0.1482 0.1753
(0.025) (0.038) (0.027) (0.034) (0.057) (0.037) (0.039) (0.062) (0.040)
Observations 6,457 6,457 6,457 3,091 3,091 3,091 2,613 2,613 2,613
R-squared 0.4859 0.3840 0.5009 0.3842 0.5065 0.3800
(continued)
Table 3. Continued.
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Top30%–vs.70% Top30%–vs.70% Top30%–vs.70% Top30%–vs.30% Top30%–vs.30% Top30%–vs.30% Rated—vs.30% Rated—vs.30% Rated—vs.30%
F test 70.7048 85.3545 48.2140 39.0770 41.9159 34.6547
Prob > F 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
Number of firmid 475 475 395 395 340 340
Chi2 test 1479.8042 971.2653 882.5157
Prob > Chi2 0.0000 0.0000 0.0000
The table presents estimates of Eq. (1) using annual data of UK listed non-financial firms for the period from 1989 to 2010. Columns 1, 4 and 7 report results from pooled OLS, columns
2, 5 and 8 report results from fixed effects and columns 3, 6 and 9 report results from random effects. Public bond market access is proxied by a firm size dummy. Columns 1–3 pre-
sent results where access is measured by Top30%–Remaining70%; columns 4–5 present results where access is measured by Top30%–Bottom30%; columns 7–9 present results where
access is measured by Rated—Small30%. The dependent variable is the ratio of total debt to the market value (MV) of assets. Industry dummies are included across all OLS and RE
specifications to control for industry-specific effects. Variables definitions are presented in Appendix 1. Standard errors (in parenthesis) are adjusted for heteroskedasticity and clustering
by firms.
, ,  indicate statistical significance at 1%, 5%, and 10% levels respectively.
107
securing a credit rating. Faulkender and Petersen (2006) note that firms need to be of a
certain minimum size to make it cost effective to issue capital market debt.
Liu and Malatesta (2005) argue that firms with low profit levels and therefore a
high risk of default are less likely to use public debt because of the higher costs in
financial distress of negotiating with wide ranging public debt holders than with a
group of private debt holders. An and Chan (2008), however, make an opposite pre-
diction in relation to firm profitability and suggests that more profitable firms are less
likely to get a rating since they have more internal funds and thus lower demand for
external funds such as bond market debt.
Growth opportunities are measured by R&D expenditure and market-to-book ratio
and are expected to be negatively related to having a rating as firms with higher
growth opportunities tend to use private debt rather than public debt (An and Chan
2008). An and Chan (2008) argue that it is easier for firms with more tangible assets to
issue public bonds and therefore obtain a rating as tangible assets serve as a collateral
when issuing debt. Additionally, An and Chan (2008) and Faulkender and Petersen
(2006) argue that firm age might also be an important determinant of whether a firm
has a rating or not as more mature firms have a better track record of issuing debt,
hence, they are more likely to get a rating.
For our first instrument we include variables that measure the percentage of firms in a
given industry with a credit rating. Faulkender and Petersen (2006) argue that if more firms
in an industry have public debt and therefore a rating the easier it is for firms to issue
public debt because the bond market possesses greater knowledge about this industry
which lowers the costs of collecting information for a bond underwriting. We use the per-
centage of firms in the industry and the natural log of 1 plus the percentage of firms.
For the next two instruments we use indicators of how well a firm is known to the
market. Faulkender and Petersen (2006) argue that the more known a debt issuer is
the easier it is for a bank to introduce the firm to the capital markets and therefore
the more likely the firm will raise public debt and thus require a credit rating.8 In this
study we use two measures of firm visibility. These are:
i. Whether the firm is in the top 30% of firms according to market capitalization.
Larger firms have higher probability having a rating due to large costs associated
with issuing a rating.
ii. Whether it is cross-listed in the United States. A firm that is cross-listed in the
US is going to be visible to potential investors in the US capital markets, which
includes the world’s largest public debt market. A cross-listing in the US estab-
lishes name recognition of the firm in the US capital market, thus paving the
way for the firm to source new equity or debt capital in this market. Therefore
as well as promoting firm visibility we would argue that firms that are listed in
the US are more likely to source the US capital markets for debt funding.
Furthermore, since in order to source debt funds in the US firms require a rating
from a recognised credit rating agency, we would expect cross-listed firms to
more likely possess a credit rating.9 In this study we use the existence of
American Deposit Receipts (ADRs) as an indicator of having a listing on the
US exchanges.
4.2. Instrumental variable regression results

We report our results from the 2-SLS IV regression and a standard OLS IV approach in
Table 4. In columns 1–2 we present results from the first stage probit regression; in
columns 3–4 we present results from the second stage IV regression;10 and in columns
5–6 we present results from a standard OLS IV regression.
Our results in Table 4, columns 1 and 2, show that the more firms in a given indus-
try have a rating the higher the probability of a firm in that industry to have a debt
rating and that larger firms are more likely to possess a credit rating. This is consistent
with Faulkender and Petersen’s (2006) results. Having an ADR is positively correlated
with having a debt rating, and the relationship is statistically significant (p-value
< 0.01). Our instruments possess good statistical properties for an instrument in the
first stage. Furthermore first stage F-statistics are considerably greater than 10 (F-stat
¼ 684.79) (as a rule of thumb for a single endogenous regressor), hence we can con-
clude that our instruments are very strong.
Similar to Faulkender and Petersen (2006) we find that some of our firm-level fac-
tors that are associated with higher leverage ratios are also related to the possession
of a credit rating. Older firms are more likely to have a rating. However contrary to
Faulkender and Petersen (2006) we do not find evidence in support that firms with
more tangible and less volatile assets have access to bond markets. An and Chan
(2008) also do not find support for positive relationship between asset tangibility and
credit rating. We find that profitability is positively and significantly related to rating,
which is contrary to the findings of Faulkender and Petersen (2006) and An and Chan
(2008), however is consistent with the argument of Liu and Malatesta (2005) that firms
with low profitability tend to avoid issuing public debt. We also find evidence in sup-
port of rated firms having less short-term debt in their structure, which is consistent
with the notion that rated firms have access to debt of longer maturities.
After instrumenting for having a rating our results from the second stage IV regres-
sion show that rated firms have higher leverage ratios. Possession of a credit rating
increases firm leverage by 5.7% (columns 3 and 4, Table 4). When we use linear
regression instead of probit in the first stage, the effect of credit rating on leverage
ratios is even larger, 6.7%.
4.3. Treatment effects method

According to Bascle (2008) measurement errors in dummy variables cannot be
adequately addressed with traditional IV methods like the 2SLS estimation (Bascle
2008, 287). If there is a self-selection problem then an alternative method, such as a
Heckman-type model, should be used in conjunction with the IV approach. Self-selec-
tion occurs when firms in our sample are not randomly selected into the rated cat-
egory. When self-selection is present the parameter estimates from the ordinary OLS
regression model will be inconsistent and biased. An and Chan (2008) argue firms to
some extent determine whether they obtain a rating by assessing the costs and bene-
fits of possessing a rating. Firms choose to have a rating if the benefits of having a
rating, such as having access to the public bond markets, offset the costs of acquiring
and maintaining a rating. Therefore the rating dummy variable is not statistically
Table 4. Instrumenting for having a rating: 2SLS IV regression (probit based method and method
based on linear regression in the first stage).
(3) IV 2nd (4) IV 2nd (5) Linear (6) Linear
VARIABLES (1) Probit (2) Probit stage stage regression regression
Industry 3.9792
(0.314)
Log industry 5.5139
(0.415)
Top30% 1.4348 1.4391
(0.054) (0.055)
ADR 0.7696 0.7788
(0.056) (0.057)
Credit rating 0.0570 0.0569 0.0678 0.0665
[0.008] [0.008] [0.008] [0.008]
Age 0.0939 0.0934 0.0079 0.0079 0.0072 0.0073
(0.027) (0.027) [0.002] [0.002] [0.002] [0.002]
Asset tangibility 0.0868 0.0616 0.0934 0.0934 0.0916 0.0918
(0.129) (0.130) [0.009] [0.009] [0.009] [0.009]
R&D expenditure 0.0080 0.0054 0.0081 0.0081 0.0082 0.0082
(0.069) (0.069) [0.004] [0.004] [0.004] [0.004]
Market-to-book 0.0156 0.0178 0.0949 0.0949 0.0949 0.0949
(0.051) (0.052) [0.004] [0.004] [0.004] [0.004]
Profitability 0.6324 0.6415 0.1657 0.1657 0.1668 0.1667
(0.153) (0.154) [0.013] [0.013] [0.013] [0.013]
Short-term debt 0.3154 0.3034 0.0789 0.0789 0.0777 0.0779
(0.094) (0.094) [0.006] [0.006] [0.006] [0.006]
Equity return 0.0029 0.0049 0.0749 0.0749 0.0749 0.0749
(0.065) (0.065) [0.006] [0.006] [0.006] [0.006]
Assets volatility 0.0364 0.0696 0.3422 0.3422 0.3418 0.3418
(0.215) (0.216) [0.017] [0.017] [0.017] [0.017]
Tax paid 0.1060 0.1015 0.0347 0.0347 0.0348 0.0347
(0.077) (0.077) [0.006] [0.006] [0.006] [0.006]
Market return 0.0619 0.0793 0.0400 0.0400 0.0394 0.0395
(0.158) (0.159) [0.012] [0.012] [0.012] [0.012]
GDP 0.0269 0.0262 0.0080 0.0080 0.0080 0.0080
(0.013) (0.013) [0.001] [0.001] [0.001] [0.001]
Constant 3.3785 3.6041 0.2784 0.2784 0.2785 0.2785
(0.195) (0.201) [0.012] [0.012] [0.012] [0.012]
Observations 6,463 6,463 6,463 6,463 6,463 6,463

LR Chi-2 2653.9668 2672.4584
Prob Chi-2 0.0000 0.0000
Pseudo R2 0.4194 0.4223
R-squared 0.5350 0.5351 0.5325 0.5329
F-stat 248.8649 249.0389 248.7270 248.8201
craggF 3577.6281 3633.4023 1049.4746 1052.6965
Hansen J 94.851 17.319
Chi-sq P-value 0.0000 0.0000
F-stat 684.79 696.11
P-value 0.0000 0.0000
AP Chi-sq 2062.35 2096.45
P-value 0.0000 0.0000
AP F 684.79 696.11
AP R-squared 0.3284 0.3291
Shea R-squared 0.3284 0.3291
The table presents results from estimating an IV regression using two alternative methods: 1.using a probit based
method in the first stage and 2. using a linear regression for the first stage. In columns 1 and 2 we report results
from the first stage probit regression, where credit rating dummy is the dependent variable, which is regressed on
firm-level factors and instruments. Instruments are (1) the percentage of firms in a given industry with a credit rat-
ing; (2) whether the firm is in the top 30% of firms according to market capitalisation; (3) whether it is cross-listed
in the United States. In columns 3 and 4 we report results from the second stage regression, where the firm’s lever-
age is regressed onto the predicted probability values for credit rating variable from the first stage probit regres-
sions and firm-level factors. In columns 5 and 6 we report results from the second method of IV estimation based
on linear regression in the first stage.
independent of leverage. Liu and Malatesta (2005) also mention that credit ratings
arise endogenously as a consequence of a decision made between firms and rating
agencies, which can lead to biased estimates of the effect of having a credit rating
on leverage.
To account for self-selection bias in our analysis we use a treatment effect model.
Treatment effect is a Heckman-type model which is relevant to our analysis as our
sample includes firms with and without credit rating, i.e. CreditRating dummy variable
that takes the value of 1 when a firm has got a rating and CreditRating dummy vari-
able that equals to zero otherwise. This method was also used by An and Chan (2008)
and Liu and Malatesta (2005) to address self-selection problem in their analyses.
The treatment effect model consists of two stages. Following An and Chan (2008)
and Liu and Malatesta (2005) we first estimate a selection equation, which models a
firm’s decision to receive a rating:
CreditRatingit ¼ cZit þ uit (2)
CreditRatingit ¼ 1 if CreditRatingit >0, and CreditRatingit ¼ 0 otherwise

Prob(CreditRatingit ¼ 1) ¼ A(cZit)
Prob(CreditRatingit ¼ 0) ¼ 1  A(cZit)
When CreditRatingit > 0, CreditRatingit ¼ 1: Leverageit ¼ d0 þ k(cZit þ uit) þ d1Xit þ eit
When CreditRatingit 0, CreditRatingit ¼ 0: Leverageit ¼ d0 þ d1Xit þ eit
where Zit are a set of observed variables that affect the probability of a firm being
rated; uit is an error term with mean zero and variance equal to one; A(cZit) is the
cumulative distribution function of the standard normal random variables. Zit includes
instrumental variables and other firm-level factors associated with having a rating. We
use the same instrumental variables for the selection equation in this section as in the
previous instrumental variable section 4.1. These include: 1. the percentage of firms in
a given industry with a credit rating, and the natural log of 1 plus the percentage of
firms; 2. two measures of firm visibility: whether the firm is in the top 30% of firms
according to market capitalisation; 3. whether it is cross-listed in the United States.
In the second stage we estimate the following regression equation:
Leverageit ¼ d0 þ kCreditRatingit þ d1 Xit þ eit (3)
where Xit is a set of exogenous firm-specific variables;

CreditRatingit is a dummy variable equal to one if the firm has a credit rating and
0 otherwise;
eit is an error term with zero mean and variance equal to one.
Similar to the previous section we include macroeconomic control variables and
industry dummies in the model.
The coefficient of interest is k, which measures the average effect of possessing a
rating on a firm’s leverage. By using a treatment effects model, we can estimate the
regression coefficients k on our endogenous dummy variable CreditRating by using
the observed variables Zit. We estimate a treatment effect model using both the max-
imum likelihood estimator and a two-step procedure.
Table 5. Treatment effects model: MLE and two-step estimation methods.
112
(1) (2) (3) (4) (5) (6) (7) (8)

Probit 2nd stage Probit 2nd stage Probit 2nd stage Probit 2nd stage
Log industry Industry Log industry Industry
Top30% Top30% Top30% Top30%
variables ADR MLE ADR MLE ADR Two step ADR Two step
Credit rating 0.0510 0.0497 0.0485 0.0474

[0.009] [0.009] [0.008] [0.008]
Age 0.1623 0.0080 0.1589 0.0081 0.1652 0.0082 0.1617 0.0083
[0.025] [0.002] [0.025] [0.002] [0.025] [0.002] [0.025] [0.002]
Asset tang. 0.0043 0.0950 0.0281 0.0953 0.0314 0.0953 0.0051 0.0955
[0.106] [0.009] [0.107] [0.009] [0.106] [0.009] [0.106] [0.009]
R&D expend. 0.0292 0.0079 0.0275 0.0079 0.0273 0.0079 0.0259 0.0079
[0.068] [0.005] [0.068] [0.005] [0.068] [0.005] [0.068] [0.005]
Market-to-book 0.0037
A. JUDGE AND A. KORZHENITSKAYA
0.0126 0.0949 0.0059 0.0950 0.0025 0.0949 0.0950

[0.046] [0.003] [0.047] [0.003] [0.046] [0.003] [0.046] [0.003]
Profitability 0.6169 0.1652 0.6139 0.1650 0.6096 0.1649 0.6081 0.1648
[0.151] [0.010] [0.152] [0.010] [0.150] [0.010] [0.150] [0.010]
Short-term debt 0.3911 0.0794 0.3950 0.0795 0.3785 0.0797 0.3827 0.0798
[0.091] [0.006] [0.091] [0.006] [0.091] [0.006] [0.091] [0.006]
Equity return 0.0479 0.0748 0.0506 0.0748 0.0238 0.0748 0.0272 0.0748
[0.059] [0.004] [0.059] [0.004] [0.057] [0.004] [0.057] [0.004]
Assets vol. 0.1876 0.3421 0.2009 0.3422 0.1007 0.3422 0.1166 0.3423
[0.203] [0.013] [0.204] [0.013] [0.200] [0.013] [0.201] [0.013]
Tax paid 0.1039 0.0346 0.1048 0.0346 0.1015 0.0346 0.1021 0.0346
[0.075] [0.005] [0.075] [0.005] [0.075] [0.005] [0.075] [0.005]
Allsharereturn 0.0406 0.0406 0.0406 0.0407
[0.011] [0.011] [0.011] [0.011]
GDP_IMF 0.0078 0.0078 0.0078 0.0078
[0.001] [0.001] [0.001] [0.001]
Industry 2.7576 2.6594
[0.182] [0.179]
Log industry 3.6277 3.5188
[0.231] [0.228]
Top30% 1.3378 1.3413 1.3703 1.3713
[0.054] [0.054] [0.052] [0.052]
ADR 0.6689 0.6693 0.6494 0.6505
[0.052] [0.052] [0.052] [0.052]
Constant 2.6500 0.2761 2.7150 0.2760 2.6985 0.2764 2.7603 0.2763

(continued)
Table 5. Continued.
(1) (2) (3) (4) (5) (6) (7) (8)
Probit 2nd stage Probit 2nd stage Probit 2nd stage Probit 2nd stage
Log industry Industry Log industry Industry
Top30% Top30% Top30% Top30%
variables ADR MLE ADR MLE ADR Two step ADR Two step
[0.142] [0.012] [0.143] [0.012] [0.141] [0.012] [0.142] [0.012]
Athrho 0.1361 0.1285

[0.045] [0.045]
lnsigma 2.0209 2.0211
[0.009] [0.009]
Observations 6,463 6,463 6,463 6,463 6,463 6,463 6,463 6,463

Wald $2$ 7485.2123 7485.2123 7486.0261 7486.0261 7570.6348 7570.6348 7568.7872 7568.7872
Prob < $2$ 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
LR $2$ 9.6302 9.6302 8.6208 8.6208
Prob < $2$ 0.0019 0.0019 0.0033 0.0033
Hazard (lambda) 0.0159 0.0151

[0.0054] [0.0054]
Rho 0.1353 0.1353 0.1278 0.1278 0.1199 0.1199 0.1138 0.1138
Sigma 0.1325 0.1325 0.1325 0.1325 0.1325 0.1325 0.1325 0.1325
Lambda 0.0179 0.0179 0.0169 0.0169 0.0159 0.0159 0.0151 0.0151
SeLambda 0.0059 0.0059 0.0059 0.0059 0.0054 0.0054 0.0054 0.0054
The table reports results of the treatment effect model estimated by a maximum likelihood and a two-stage method. Columns 1–4 report results from a treatment model MLE and col-
umns 5–8 report results from a treatment model two-stage. Results from both the selection equation and regression equation are presented. Results from the selection equation are
presented in the preceding column of the regression equation.
, ,  indicate statistical significance at the 10%, 5%, and 1% levels, respectively.
113
Table 5 reports the results using a treatment effect maximum likelihood estimator and
a two-step procedure. The first stage results (columns 1, 3, 5 and 7) suggest that all our
instruments are positively and significantly related to leverage. They show firms that oper-
ate in industries with higher proportions of rated firms and those with higher visibility,
measured by firm size and cross-listing in the US, are more likely to have credit ratings.
Consistent with our expectation we find that older firms are more likely to possess a credit
rating. However, contrary to our prediction we find that more profitable firms are more
likely to have a credit rating, which is consistent with the result in the Instrumental
Variable section. The coefficient on short-term debt is negative and significant, providing
evidence that rated firms have less short-term debt in their capital structure.
Our second stage results in Table 5 suggest that applying the treatment effect model
is appropriate. Columns 1–4 report results from the treatment effect MLE. Here we test
the hypothesis that the correlation coefficient between the error term of the regression
Eq. (2.3) and the error term of the selection Eq. (2.2) equal to zero, i.e.
corr(eit,uit)¼q ¼ 0.The values of the chi-square test are v2¼ 9.63 (p < .001) and v2¼ 8.62
(p < .001). We can therefore reject the null hypothesis at a statistically significant level
(columns 1–4) and conclude that the correlation coefficient rho (q) is not equal to zero.
This result suggests that there is a self-selection bias and justifies the use of the treat-
ment effect model. Columns 5–8, Table 5, report results from the two-step treatment
effect model. In this estimation one of the key parameters is the inverse Mills ratio. The
inverse Mills ratio, denoted as lambda, (lambda, column 6 ¼ 0.0159 and lambda,
column 8 ¼ 0.0151) also confirms that there is a selection bias.
The goodness of fit of the model is given by the Wald test of all coefficients in the
regression model being equal to zero. In all our treatment models the Wald test is
large and significant at 1% level (v2 ¼ 7485, p < .0001). We can therefore conclude
that at least one of the variables used in the regression model is not equal to zero
and the variables fit the model well.
Consistent with our previous results firms with a credit rating have more leverage.
The estimated coefficients on a credit rating dummy are positive and statistically sig-
nificant at the 1% level. The results suggest that credit ratings by providing access to
capital markets increase debt and lead to higher leverage ratios. The coefficients on
the control variables are mostly consistent with the previous results. Firm size is posi-
tive but insignificant. Older firms with more tangible assets have more leverage. Firms
with higher growth opportunities measured by market-to-book ratio have less lever-
age. The coefficient on R&D expenditure is not significant. Our results show that profit-
ability, the level of short-term debt, equity return, asset volatility and tax paid are
negatively related to leverage consistent with our previous results.
5. Conclusion
This paper examines the role played by credit ratings in determining capital structure
choice for a large sample of UK non-financial firms. A credit rating benefits firms not
only by providing access to local public bond markets, but having a rating from one
of the major agencies (S&P or Fitch) gives an opportunity to issue bonds in the inter-
national debt capital markets. For UK firms this is especially important, since a rating
can ‘open the door’ to the U.S. capital market—the largest and most liquid source of
debt capital.
The empirical analysis in this study utilises data over a 22 year period from 1989 to
2010. In line with the empirical literature (Faulkender and Petersen 2006; Kisgen 2007;
Leary 2009) public debt market access is measured by the possession of a credit rating
and firm size dummies. Using both pooled OLS and panel regression methodology
our results indicate that firms with access to public debt markets have higher leverage
ratios after controlling for demand-side determinants of capital structure. The empirical
results demonstrate that supply side factors are an important determinant of capital
structure choice for UK non-financial firms. The results suggest that for the full sample
of firms the possession of a rating increases leverage by around 4 per cent for UK
firms over the period 1989 through to 2010. When we restrict our sample to rated
firms and those in the bottom 30 per cent of the firm size distribution the effect of
having a rating on leverage is much greater, with the rating coefficient ranging
between 5.7 and 7.2 per cent. When we control for endogeneity of having a rating
our results remain qualitatively similar. After instrumenting for having a rating we find
that the coefficient is around 5.5–6.7 per cent. When controlling for self-selection bias
we find that rated firms have around 5 per cent higher leverage. Overall, our results
show that access to bond markets as measured by the possession of a credit rating
had an economically and statistically significant positive effect on the level of leverage
for UK firms over our sample period.
The effect of possessing a rating on leverage reported in this study is larger than the
2.8 per cent found by Leary (2009) in a comparable study that employs a sample of US
firms during the period 1965 to 2000. This difference might be in part due to differences
in the composition of the samples employed in our study or the period under investiga-
tion, compared to that of Leary (2009). For example, our period, 1989 to 2010, incorpo-
rates two recessions and three episodes of severe credit market tightening, whereas the
years covered by Leary (2009) were relatively benign when it comes to credit market
conditions according to the US Federal Reserve Loan Officer data. We would expect the
importance of having a rating to be greater during tighter credit markets. Alternatively,
it might also be due to differences in the level of corporate disclosure between the UK
and the US. It has been suggested that US companies have a relatively easy time raising
external finance and enjoy a highly liquid capital market because the United States
imposes fairly stringent disclosure laws. In the US the Securities and Exchange
Commission (SEC) set the rules for corporate disclosure. These rules require substantial
disclosure of financial information and regular reporting to the SEC. Thus, the US is a
richer reporting environment with strong monitoring and regulation. Although report-
ing and disclosure standards in the UK are rigorous they are not as stringent as those in
the US. In markets where there is less disclosure investors will be less willing to buy
stock at higher prices, market liquidity is likely to be lower, and debt capital for corpor-
ate expansion will be more difficult to raise. Given that there is far greater corporate
financial transparency in the US compared to the UK it follows that the additional finan-
cial information released to investors from having a rating is likely to be greater in the
UK than the US. All else being equal this would result in greater debt access effects from
having a rating in the UK. Another explanation for the higher debt rating effect we find
is that leverage levels on average in the UK are lower than those in the US. For example,
Rajan and Zingales (1995) report that firms in the UK are ‘substantially less levered’ than
their counterparts in the US. It follows that if UK firms are starting from a lower base the
incremental impact on leverage due to having a credit rating would be greater for UK
than US firms.
An important implication of our findings is that as having a credit rating (i.e. access
to debt capital markets) increases firm leverage it could have a positive impact on
firms investment spending decisions. Firms without a rating could find themselves
financially constrained and therefore not fully able to undertake the investment oppor-
tunities available to them. Perhaps more so during a period of credit market tighten-
ing when you might find that bank lending has contracted. We leave it to future
research to examine whether access to capital market debt via a credit rating plays an
important role in explaining firm investment.
Notes
1. Results are available from the authors upon request.
2. As a robustness test we also estimate each specification using a random effects model. To
test whether the results (i.e. the estimated coefficients) from the fixed effects and random
effects model are significantly different we run a Hausman test.
3. A Hausman test suggests that the coefficients of our FE and RE model are different and so
the RE estimator is inconsistent. We therefore prefer the FE estimation. This also suggests
that there is omitted variable bias that the RE model has not accounted for whereas the
FE model has.
4. Leary (2009) includes three macroeconomic control variables: growth in GDP over the
previous year, aggregate nonfinancial corporate profit growth and the equity market return.
5. We note that the General Methods of Moments (GMM) Arellano and Bond estimator is not
valid on a long panel in the time dimension. If many firms of the sample are present
during more than 10 consecutive years, the GMM method will lead to too many
instrumental variables.
6. Following Faulkender and Petersen (2006) we use Probit estimation method in the first
stage due to our credit rating variable being a dummy, instead of a standard instrumental
variable estimation where first stage is a linear probability model. According to Faulkender
and Petersen (2006) a linear probability model in the first stage would not work as this is a
misspecification of the data, whereas the Probit method should give consistent coefficients
and correct standard errors.
7. This method was used by Faulkender and Petersen (2006) and An and Chan (2008) to
control for endogeneity of having a rating.
8. Faulkender and Petersen (2006) use whether a firm is in the S&P 500 and whether it trades
on the NYSE as proxies for firm visibility and therefore as instrumental variables.
9. Two formal credit ratings are required to issue a public bond in the US debt markets.
10. Following Faulkender and Petersen (2006) and An and Chan (2008), we use the predicted
probability of first stage Probit estimation as an instrument in the second stage of the estimation.
Acknowledgments
We are very grateful to Standard and Poor’s and Fitch Ratings for providing us with credit rating
data. We thank an anonymous referee for useful comments and suggestions. Thanks also to Ian
Stewart, John Grout, Blaise Ganguin, Aneel Keswani, Marian Rizov, David Kernohan and Valeria
Unali for their suggestions. We thank seminar participants at the University of Santiago de
Compostella, Cass Business School, University of Porto, ISCTE Business School, Bank of England,
Standard and Poor’s, Joint Seminar at the Department for Business, Innovation and Skills and
HM Treasury, GdRE Symposium on Money, Banking and Finance at Reading University and
Middlesex University for helpful comments and suggestions. The usual disclaimer applies.
ORCID
Amrit Judge http://orcid.org/0000-0001-9793-8166
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Do Credit Ratings Determine Capital Structure?

Amrit Judge & Anna Korzhenitskaya

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Do Credit Ratings Determine Capital Structure?

the leverage of bank-dependent firms significantly declined compared to firms with

3. Sample, data and empirical analysis

3.2. Empirical analysis

3.2.2. Multivariate analysis

Leverage is measured by the debt-to-asset ratio;

Credit rating 0.0343 0.0432 0.0462 0.0307 0.0400 0.0416

3.2.3. Robustness tests: alternative measures of access

 Correlation between size and Top30%–Remaining70% ¼ 0.66

Top30%–Remaining70% 0.0218 0.0139 0.0177

(0.018) (0.017) (0.016) (0.021) (0.022) (0.021) (0.022) (0.023) (0.021)

4.2. Instrumental variable regression results

4.3. Treatment effects method

Observations 6,463 6,463 6,463 6,463 6,463 6,463

CreditRatingit ¼ 1 if CreditRatingit >0, and CreditRatingit ¼ 0 otherwise

where Xit is a set of exogenous firm-specific variables;

(1) (2) (3) (4) (5) (6) (7) (8)

Credit rating 0.0510 0.0497 0.0485 0.0474

0.0126 0.0949 0.0059 0.0950 0.0025 0.0949 0.0950

Constant 2.6500 0.2761 2.7150 0.2760 2.6985 0.2764 2.7603 0.2763

Athrho 0.1361 0.1285

Observations 6,463 6,463 6,463 6,463 6,463 6,463 6,463 6,463

Hazard (lambda) 0.0159 0.0151

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