Do Credit Rating Agencies Underestimate Liquidity Risk?

We test if credit ratings adequately reect liquidity risk, i.e., the risk that the rm may face di-culty in renancing its short-term debt. Consistent with credit ratings underestimating liquidityrisk, we nd that after controlling for credit ratings and other known determinants, long-termbonds of rms with a higher proportion of short-term debt trade at higher yields. Using multi-notch downgrades to identify severe and unexpected rating downgrades, we nd that rms with ahigher proportion of short-term debt are more likely to experience multi-notch downgrades. Theassociation between short-term debt and multi-notch downgrades is stronger in industries thatexperience a negative protability shock, during recessionary periods and when credit conditionsare tight. The relationship is robust to instrumenting the proportion of short-term debt. Overall,our results highlight that rating agencies underestimate liquidity risk, and oer a potential ex-planation for the failure of ratings to predict nancial diculties at rms such as Penn Central,WorldCom, Enron, Bear Stearns and Lehman Brothers.