Credit ratings play an important role in converging opinion about the creditworthiness of financial instruments. New research explores how this role took shape by analysing the impact of the first rating system for bonds in the early 20th century.
Credit ratings are rarely far from the news. To most observers, their information value on the creditworthiness of debt issuers is nowadays largely tied up with their certification and regulatory roles in credit markets. Their original value in the early 20th century, however, has not been fully explored.
Our new research, which analyses a large amount of hand-collected data from 1909–14, shows credit ratings reduced disagreement and uncertainty surrounding the valuation of rated bonds – and decreased their volatility. The enduring success of credit ratings can be traced back to their initial effectiveness in capturing investors’ attention and converging opinions across bond markets.
John Moody published the first rating manual for securities issued by steam railroad companies in 1909, and securities issued by public utility and industrial companies in 1914. Importantly, this time period predates the regulatory role of credit ratings, which began in the 1920s with US courts referring to them in judgements, and was codified in 1936 when banks were prohibited from investing in securities rated below investment grade. It also captures a period when ratings were only given once bonds had already been issued (which is no longer the case), providing data on trading before and after a rating was assigned.
There were already some sources of information available to help investors make informed decisions prior to the early 20th century. Stock and bond prices were reported in national business newspapers, while financial information on firms was provided in several dedicated manuals. At the time, however, only the largest institutional investors were able to process that information and make use of it. Smaller bodies and retail investors were mainly reliant on buy/sell recommendations from investment banks.
Credit ratings reduced disagreement and uncertainty surrounding the valuation of rated bonds –and decreased their volatility
Moody’s publications provided for the first time a comprehensive overview of companies and their securities in one place, and they did so in a way that even unsophisticated investors could understand: using rating symbols. These were intuitive and memorable, and research has since confirmed that pictorial information is more easily recalled than verbal information. The manuals also included a transparent methodology, which helped to reassure investors that the ratings were objective.
Public opinion at the time was generally positive, with the first edition of Moody’s Analyses of Railroad Investments selling out in three months, and the New York Evening Post noting that it “should prove valuable to bankers [and] investors”.
Overall, Moody’s ratings were successful in attracting the attention of investors, who saw their practical benefit. Research has found that where this attention and learning coexist, there is a reduction in financial uncertainty and a corresponding fall in price volatility.
We hypothesised that, on the back of securing investor attention, Moody’s credit ratings served to homogenise information and strengthen investor consensus around bond prices, leading to a reduction in the valuation uncertainty and volatility of rated bonds. We also hypothesised that bonds with higher valuation uncertainty before being rated experienced a more significant decrease in volatility after receiving a rating.
This historical basis for the market benefit of credit ratings sheds new light on their enduring value to investors
Our research tested these two hypotheses, by way of analysing hand-collected data on bond ratings from the Moody’s rating manuals published each year from 1909–14. We found that, following the publication of the first ratings, the volatility of rated bonds decreased in comparison to the volatility of non-rated bonds. Additionally, we found that the contraction in volatility was economically larger for bonds that received a rating that would be considered speculative according to today’s standards, i.e. those characterised by a high degree of valuation uncertainty.
Our research showed investors did indeed actively learn about the quality of bonds from ratings, and that this information made the valuation of rated bonds more precise. The reduction in bond volatility that we observed is most likely the result of a combination of the attention spurred by the new ratings symbols, and the increased level of agreement among investors about the creditworthiness of rated bonds. Essentially, Moody’s success in attracting investors’ attention to his ratings facilitated the incorporation of information into bond prices.
This historical basis for the market benefit of credit ratings sheds new light on their enduring value to investors, and gives us some understanding of how they came to embody their now-vital role in our economic systems. Using easily interpreted data, a transparent methodology, and broad investor attention, credit ratings have for more than a century been able to shape investors’ opinions in credit markets.
This article draws on findings from "Credit Ratings and Bond Volatility: Early Evidence from the Introduction of Credit Ratings", by Mascia Bedendo (University of Bologna), Lara Cathcart (Imperial College London) and Lina El-Jahel (University of Auckland).