Credit Ratings: Heterogeneous Effect on Capital Structure

TL;DR

This paper uses double machine learning with random forests to identify how credit ratings causally influence company leverage, revealing highly heterogeneous effects across different rating categories and a gradual change within rating notches.

Contribution

It introduces a novel application of double machine learning to analyze the heterogeneous causal impact of credit ratings on leverage, without strong functional form assumptions.

Findings

Credit ratings causally increase leverage by 7-9 percentage points.

Effects vary by rating: negative for AAA/AA, zero for A/BBB, positive for BB and below.

The change in effect is gradual across rating notches, not abrupt at grade boundaries.

Abstract

Why do companies choose particular capital structures? A compelling answer to this question remains elusive despite extensive research. In this article, we use double machine learning to examine the heterogeneous causal effect of credit ratings on leverage. Taking advantage of the flexibility of random forests within the double machine learning framework, we model the relationship between variables associated with leverage and credit ratings without imposing strong assumptions about their functional form. This approach also allows for data-driven variable selection from a large set of individual company characteristics, supporting valid causal inference. We report three findings: First, credit ratings causally affect the leverage ratio. Having a rating, as opposed to having none, increases leverage by approximately 7 to 9 percentage points, or 30\% to 40\% relative to the sample mean leverage. However, this result comes with an important caveat, captured in our second finding: the effect is highly heterogeneous and varies depending on the specific rating. For AAA and AA ratings, the effect is negative, reducing leverage by about 5 percentage points. For A and BBB ratings, the effect is approximately zero. From BB ratings onwards, the effect becomes positive, exceeding 10 percentage points. Third, contrary to what the second finding might imply at first glance, the change from no effect to a positive effect does not occur abruptly at the boundary between investment and speculative grade ratings. Rather, it is gradual, taking place across the granular rating notches ("+/-") within the BBB and BB categories.