In the early twentieth century, the New York Stock Exchange saw the active trading of numerous corporate bonds, yet investors faced limited information about these securities. This scenario changed in 1909 when John Moody introduced a letter-grade system to rate bonds, offering investors a simplified yet crucial tool for evaluating risk. Carola Frydman, a finance professor at the Kellogg School, along with researchers Asaf Bernstein and Eric Hilt, explored the transformative impact of Moody's innovation on financial markets.
By analyzing archival data covering more than 500 bonds before and after Moody's 1909 introduction, the researchers aimed to assess how bond ratings influenced the market. Their findings revealed that Moody's ratings not only impacted bond markets but also enhanced their functionality. The introduction of ratings focused solely on the informational value of the letter-grade system, improved market participation and allocation of capital, and spurred financial development.
Bond ratings, designed to predict default likelihood and potential creditor recovery, convey valuable information to investors. The researchers tested the impact of Moody's ratings by examining instances of "negative surprises" when a bond received a lower rating than its peers with similar yields. The study found that bonds experiencing a negative rating surprise saw a subsequent increase in yields, indicating the market's acknowledgment of Moody's ratings as significant new information.
Moreover, the researchers explored whether ratings reduced trading costs in financial markets. Bid-ask spreads, representing the cost of trading, became a focal point. The analysis showed that Moody's ratings led to substantially lower bid-ask spreads, signifying more liquid and well-functioning financial markets.
Interestingly, the study suggested that Moody's ratings were particularly beneficial to small investors. Post-1909, single-lot trades, commonly used by small investors, increased, while large-lot trades did not. This implied that smaller investors felt empowered to enter the bond markets after the introduction of Moody's ratings, leveling the playing field.
Carola Frydman emphasized the importance of understanding the historical impact of ratings on financial markets. Despite concerns about the credibility of ratings stemming from the 2008 financial crisis, Frydman argued that the core value of bond ratings lies in their ability to aggregate and transmit information efficiently.
The study also highlighted lessons for emerging economies establishing their own rating agencies and for modern financial markets, suggesting that simplicity and standardization matter, especially in areas like ESG (environmental, social, and governance) ratings.
