Finance & Accounting Oct 1, 2023
The Enduring Power of Bond Ratings
In 1909, John Moody handed out his first As, Bs and Cs. The market would never be the same.
In the early twentieth century, hundreds of different corporate bonds were listed and actively traded on the New York Stock Exchange. Yet investors had relatively limited information about these bonds and the companies that issued them. Several firms, including Standard Statistics and Poor’s, compiled basic financial information on these corporations and their securities in books that they sold to investors, but this information was not easy to interpret. Many investors likely found it difficult to determine which bonds were safe or risky.
In 1909, John Moody began rating bonds using a newfangled letter-grade system and selling that information to investors in an annual volume. The ratings were to a large extent a simplified repackaging of publicly available information—yet they would go on to become one of the financial world’s most important and widely recognized tools.
“Today, we don’t think about bond markets in the absence of bond ratings,” says Carola Frydman, a professor of finance at the Kellogg School and coauthor—along with Asaf Bernstein of the Leeds School of Business and Eric Hilt of Wellesley College—of new research examining how Moody’s innovation transformed financial markets. “To that point, this is the first paper, as far as I know, that looks at the effects of the ratings’ introduction.”
To explore whether the information transmitted by bond ratings influenced the market upon its arrival, the researchers hand-collected archival data about more than 500 bonds, spanning the period before and after the introduction of Moody’s 1909 volume. Their analysis reveals that the ratings did influence bond markets—and also improved the functioning of those markets, in part by encouraging the involvement of smaller investors.
Returning to the origins of the ratings allowed the researchers to zero in on the pure informational value of the letter-grade system, rather than the business and regulatory infrastructure that has grown up around it.
“One of the takeaways,” says Frydman, “is that developing credible rating agencies that can process information—and convey it in a good way—can help the functioning of markets, boost participation in markets, improve the allocation of capital in the economy, and spur financial development.”
A bond’s rating is designed to transmit a prediction about two of its most salient features (in investors’ eyes): first, the likelihood that a bond will default and, second, the amount of their capital creditors can expect to recover in that worst-case scenario.
Markets communicate their own predictions of these factors via bond yields, which are the annual rates of return they pay investors. A bond’s yield rises with the perception of its riskiness.
To test whether Moody’s ratings made an impact on bond markets, Frydman and her colleagues looked for instances in which a rating constituted a “negative surprise”—that is, cases in which Moody stamped a bond with a rating lower than that of its peers with similar yields. The researchers expected that, if the ratings had been received by the market as important new information, bonds hit with a negative rating surprise would see their yields increase.
“[D]eveloping credible rating agencies that can process information—and convey it in a good way—can help the functioning of markets, boost participation in markets, improve the allocation of capital in the economy, and spur financial development.”
The researchers also wanted to understand whether ratings may have reduced the costs of trading in financial markets. In John Moody’s era, as now, officially designated traders referred to as market makers facilitated the functioning of these markets by buying bonds at what is called the “bid price” and selling at what is called the “ask price.” The difference between these two prices—commonly called the bid–ask spread—is essentially a cost one pays for trading in these markets, like a built-in fee.
Market makers must always be willing to buy and sell bonds to facilitate trading, but they face significant risks: if buyers or sellers know something they don’t, they could take losses if prices move against them. The bid–ask spread is therefore set higher the more worried market makers are about being at an information disadvantage.
For the researchers, then, bid–ask spreads offered important information: if spreads tightened for bonds rated in 1909, relative to similar but unrated bonds, this would suggest ratings reduced concern about information differences and the costs of trading and participating in financial markets.
When they completed their analysis, the researchers found that Moody’s ratings were received as notable information by the market, judging by the reaction of bond yields. Specifically, negative-rating surprises led to yield increases of 3 to 5 percent.
What’s more, the ratings did lead to substantially lower bid–ask spreads, indicating the presence of more liquid and well-functioning financial markets.
The researchers also uncovered some evidence that ratings were particularly useful to small investors. When they looked at the number of shares bought or sold in a given transaction, they found that single-lot trades, the type used by small investors, increased post-1909, while large-lot trades did not. This suggests that smaller investors felt newly empowered to enter the bond markets after Moody’s ratings were introduced. The information contained in credit ratings helped level the playing field.
“I think these findings are telling us that ratings matter,” Frydman says. “They improve markets.”
New frontiers to simplify
Frydman argues that understanding the ratings’ past can help us better understand our bond market’s present. The 2008 financial crisis raised serious concerns about the credibility of ratings and about how heavily investors and regulators have come to rely on them.
In addressing these concerns, says Frydman, it’s crucial to acknowledge that the business model around ratings has morphed since John Moody’s days. Since the 1970s, ratings agencies have charged the firms issuing bonds—not investors—for their analysis. Some worry this setup creates misaligned incentives by encouraging agencies to issuer rosier ratings and keep their issuer-customers happy.
“In any modern setting, it’s very hard to convincingly pin down whether the ratings have much value as a way to aggregate and transmit information—which is presumably what they are out to do,” says Frydman.
The research suggests that these modern problems aren’t inevitable and don’t necessarily stem from ratings themselves. In their simplest form, bond ratings offer valuable and efficiency-boosting information; it’s the infrastructure around them that may need reform.
Also embedded in the findings are lessons for emerging economies establishing their own credible ratings agencies, says Frydman—and, perhaps less obviously, for developed financial markets introducing new types of ratings.
Frydman offers the exploding field of ESG (that is, considering a security’s embedded environmental, social, and governance factors as key to investment decisions) as a prime example of an area in need of a streamlined and standardized rating system.
“There is room for simplification in the very complex ESG space,” Frydman says. “It’s about trying to figure out the key components [of the ratings] that will make them more impactful. I think that simplification really matters.”
Katie Gilbert is a freelance writer in Philadelphia.
Bernstein, Asaf, Carola Frydman, and Eric Hilt. 2023. “The Value of Ratings: Evidence from Their Introduction in Securities Markets.” Working paper.