Credit risk and rating assignments with parent-subsidiary links

This paper explores the relationship between leverage, credit risk and rating when a parent issues a guarantee for its subsidiary s debt. It analyzes the consequences of the guarantee on rating assignments, when the subsidiary s leverage is either exogenous or at its optimal level. It computes rating assignments on the basis of a structural model of credit risk for the two rms that explicitly incorporates the guarantee in favour of the subsidiary. Default probability is lower and overall credit quality - rating included - is higher in the subsidiary than in a stand alone company, thanks to the guarantee, if its debt is xed. However, the opposite result can hold at the optimal level of debt, since the guarantee allows to raise much higher external nancing from the subsidiary - thus increasing bankruptcy costs together with tax avoidance. Starting from a BBB situation, we show that, under optimal leverage, the credit standing and rating of the subsidiary can either improve or worsen, depending on the correlation between the holding and the subsidiary operating pro t. We perform a symmetric analysis for the holding. Our model reproduces the positive relationship between rating gaps in groups and selective default observed in practice. It also di¤erentiates spreads, for given rating, according to the ownership status (parent, subsidiary), while reproducing on average per-rating observed spreads.