The Notching Rule for Subordinated Debt and the Information Content of Debt Rating

Kose John, S. Abraham Ravid and Natalia Reisel

Financial Management, 2010, vol. 39, issue 2, 489-513

Abstract: This paper provides new evidence regarding the information content of debt ratings. We show that noninvestment grade subordinated issues are consistently priced too high (the yield is too low), and the reverse is true for some investment grade bonds. We relate this empirical bias to a notching rule of thumb that is used in order to rate subordinated debt without expending additional resources for information production. We propose an explanation for these findings based upon a balance between an attempt to please the companies that pay the raters versus a concern for lawsuits and regulatory investigations should ratings be too optimistic.

Date: 2010
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