Do credit ratings affect spread and return? A study of structured finance products

Whilst the previous studies investigating the relationship between credit ratings and spread or return in the financial market are normally restricted to non-causal measures, this paper uses Structural Equation Modelling (SEM) to test the possibility of causal links from ratings to spread and return in the context of structured finance products. Our analyses are split into two stages: first, we search for causality between ratings and spread at the issuance stage (primary market) based on a sample comprising all tranches of asset-backed securities (ABS) issued in the US from December 1999 to December 2015. Then, we consider all ABS rating changes from February 2001 to December 2015 to check whether the assumption of causal connection between ratings and return at the trading stage (secondary market) is reasonable. After testing all pertinent combinations among the variables in our database, we find evidence of causality at the issuance stage but very little support to causality at the trading stage. This study contributes to the debate on the regulation of credit rating agencies (CRAs) as our findings suggest that ratings may have an effective influence on decisions made by investors at the time structure finance products are issued. As this effect is very weak when those assets are traded in the secondary market, in principle, regulators should focus their attention on the CRAs’ activities regarding the issuance of new structured products.