Written on 13 May 2020

The Credit Rating-Capital Structure Hypothesis – Does CEO Overconfidence Matter?

For the first time, a new study by Shee-Yee Khoo, Huong Vu and Patrycja Klusak, links two research areas - CEO overconfidence and credit rating - contributing useful insights to board of directors of firms where CEOs are subject to overconfidence bias.

Having a good corporate credit rating assigned by an external credit rating agency (e.g., S&P, Moody’s, Fitch) is often what a company strives for. Similar to a personal credit score, a corporate credit rating determines how likely a company is to pay its debts in full and on time.  Because company insiders know far more than outsiders – causing an information asymmetry in the capital markets – credit ratings are crucial privately produced information upon which lenders rely to assess a company’s creditworthiness and hence how much interest to charge. Put simply, the higher the credit rating, the easier it is for issuers to tap the capital market for funding and the cheaper their cost of borrowing.      

Changes in credit ratings might have significant impact on corporate managers’ decisions about what debt to take on. Rating upgrades can make it easier to borrow, whereas rating downgrades restrict borrowing. In certain extreme cases, downgrades can activate rating triggers in financial contracts and impose further constraints on borrowers. This suggests companies will try to maintain a target credit rating to secure stable access to debt financing and are willing to adjust their debt policy to bring the rating closer to their target level whenever their rating changes. Such an adjustment happens when downgrades occur, whereby managers reduce leverage by reducing new debt offerings, issuing more new equity, and cutting down share repurchases. Reducing debt level can ease the debt burden on the firm’s balance sheet and increase the chance of ratings to be upgraded in the future.

This effect is not symmetrical though. There should be little incentive for managers to increase debt in response to upgrades despite the relaxation brought about by the improved creditworthiness. This is because increase in debt levels can harm the target rating in the future. Kisgen (2009) coined the term Credit Rating-Capital Structure Hypothesis to refer to such an asymmetry in the response of corporate debt policy to rating changes. He found support for the hypothesis from empirical tests on public US firms in the period 1987-2003.

Unlike Kisgen, we examine this hypothesis through the lens of corporate managers who are prone to biases in their subjective beliefs, specifically overconfidence. The trait of overconfidence is commonly found among corporate executives, particularly in individualistic countries such as the United States. Confidence is arguably one of the virtues that outstanding leaders possess. But too much of it can be devastating, particularly when it comes to judgment and decision-making. Overconfident CEOs generally believe their firms are less risky and/or more profitable than they actually are under their leadership, which subsequently has substantial impact on their capital structure decisions, i.e. choice between debt and equity. Overconfident CEOs prefer to fund investment opportunities first with retained earnings, then by debt financing and only tap equity as a last resort.

Given the particularly strong preference for debt over equity (due to debt’s tax advantages), we argue that credit ratings play a more significant role in the capital structure decisions of overconfident CEOs than non-overconfident CEOs. Relaxing the assumption that executives are rational (in the sense in which economists use the term), we find that only overconfident CEOs adjust leverage in a way that maintains a minimum credit rating level. In contrast, non-overconfident CEOs are willing to increase leverage to take advantage of a cheaper cost of borrowing brought about by a rating upgrade. Upon closer scrutiny, we also find that over-confident CEOs exhibit stronger preference for internal capital in the year following the rating upgrade. This is a direct consequence of their unwillingness to increase leverage despite the fact that debt financing becomes cheaper thanks to upgrades.

The CEO overconfidence literature has been growing alongside the credit rating literature, yet little is known about how they relate to each other. We link the two areas of research for the first time, contributing insights that could be particularly useful to board of directors of firms where CEOs are subject to overconfidence bias. Our study finds that trait of overconfidence is associated with stronger focus on maintaining or obtaining a higher credit rating. Thus, overconfident CEOs, due to their preference for debt, might be able to maintain or obtain higher credit rating compared to their non-overconfident counterparts. Boards should consider setting a limit for internal cash flow usage or a limit on new borrowing to constrain overconfident CEOs overspending.



Kisgen, D. J. (2009). Do Firms Target Credit Ratings or Leverage Levels? Journal of Financial and Quantitative Analysis, 44, 1323-1344.


The Bennett Institute Working Paper 'The Credit Rating-Capital Structure Hypothesis – Does CEO Overconfidence Matter? by Shee-Yee Khooa, (University of Aberdeen), Huong Vua  (University of Aberdeen) and Patrycja Klusak (Norwich Business School, UEA; Bennett Institute for Public Policy