In a new report Moody’s Investors Service finds a link between excessive executive compensation and the likelihood of corporate credit woes.

Moody’s say that companies that sweeten CEO compensation packages with unusually large bonuses or option grants have experienced historically higher default rates and more frequent and larger rating downgrades than their peers. “We have found that large, unexplained bonus and option awards have been associated with higher rates of default and large rating downgrades, but variation in CEO base salaries do not predict credit risk,” said Christopher Mann, a Moody’s vice president and author of the report. “This is not surprising because salary is typically only a fraction of overall compensation.”

Mann defined “unexplained” compensation as bonus and options plans that deviate substantially from what should be expected based on firm characteristics such as size, past operating performance, industry conditions, and long-term rating.

Moody’s found that of the 43 companies rated B3 or higher that defaulted between 1993 and 2003, 22 offered their CEOs much-larger-than-expected bonuses or stock option grants or both at least once. Of the 214 that experienced large downgrades, (three or more rating notches within 12 months), CEO compensation was higher than expected in 140 cases with 50 of those finishing in the top 10% in terms of the plans’ generosity.

“Not every firm with larger-than-expected compensation is necessarily a higher credit risk,” Mann cautioned. “The vast majority of the firms under study never experienced a default or a large downgrade. However, looking carefully at compensation — along with other factors — may help to highlight the effectiveness of a firm’s governance practices.”

The Moody’s report pointed to three possible explanations for this correlation, which have also been documented in other academic literature on the topic. First, excessive compensation may be indicative of weak management oversight by boards of directors. Second, large pay packages that are highly sensitive to stock price or operating performance may induce greater risk-taking by managers, “which may be consistent with stockholders’ objectives, but not necessarily with bondholders’ objectives,” said Mann. A third possible explanation is that large-incentive pay packages may lead managers to focus on accounting results, which may divert management attention from the underlying business or, at worst, create an environment that ultimately leads to fraud.

Moody’s cautions that the correlations observed between unexplained compensation and credit risk is based on historical data and may not be constant over time. The agency points to the recent move toward performance shares and restricted stock as one of the ways that executive compensation has evolved and predicts that firms will continue to experiment with new vehicles intended to induce superior managerial performance.