Credit ratings, issuer quality, and underwriter reputation in the debt market
Firms raise capital to finance investment projects by issuing debt or equity securities. In most cases these securities are marketed by investment banks that underwrite the issues. This study analyzes the association between debt issuers and their underwriters and compares the results to a similar study from the equity market. Positive assortative matching in which reputable underwriters market issues for high quality firms is present in both the equity and debt markets. In addition to positive assortative matching, there is also evidence of negative assortative matching within the debt market segments. Investment grade credit ratings in the debt market provide information about the issuing firm and certify that the security is of high quality. Firms with less than investment grade ratings or no rating must either provide an expected return high enough to induce investors to purchase the offering or find another means of certifying the issue. Results from the current study are consistent with lower quality firms using underwriter reputation as a substitute for certification from rating agencies and paying higher gross spreads to do so. Firms making subsequent issues may use the same underwriter as their previous issue or switch to another. Analysis of a firm's decision to use the same underwriter on a subsequent issue or switch to a different underwriter indicates that several of the factors that influence this decision have the reverse effect in the equity and debt markets. In the equity market, as the difference in relative firm quality and underwriter reputation increases the probability of switching underwriter increases; the majority of the evidence from the debt market indicates a decrease in the probability. The time between issues also increases the probability of a switch in the equity market and a decrease in the debt market. Previous research indicates greater benefits to lower quality issuers from using the same underwriter for multiple services. In a final analysis, a variable representing the scope of underwriter services used by each issuer-underwriter match is added to the firm quality regressions as a check of the model's robustness. Results are consistent with those from existing studies.