This essay is based on the working paper “The Value of Ratings: Evidence from their Introduction in Securities Markets” by Asaf Bernstein, Carola Frydman, and Eric Hilt.
Providing Investors with More Information Can Make Markets More Efficient
The development of the American economy has been exceptional for numerous reasons. Well-functioning financial markets that facilitate the allocation of capital are an important contributing factor to economic growth. Current markets and institutions are the result of a long-run process of change. Historical evidence suggests that changes in increased transparency and information availability have broadened market access and improved efficiency.
A few transformative changes were implemented in response to market crashes. For example, the Securities and Exchange Commission (SEC) was founded in the aftermath of the Great Depression with the mission to protect investors, facilitate investment in businesses, and enhance the efficiency of US financial markets. Before the creation of the SEC, individual investors or small financial institutions seeking to buy stocks or bonds knew little about these securities issuers. They did not know who owned these corporations or how much their executives were paid. In certain cases, they even lacked access to income statements or balance sheet information. While mandates to disclose financial information were codified in the regulation after the Great Depression, other significant changes in the transparency and availability of financial information have occurred almost haphazardly. Along with my colleagues Asaf Bernstein and Eric Hilt, I study one such change—the first-ever introduction of ratings in securities markets.
Facilitating Investment in Railroads
Access to external finance was essential for the development of railroads in the nineteenth century and, subsequently, for utilities and industrial trusts. These large enterprises—a key engine of growth and innovation—required large investments in physical assets and, therefore, required levels of capital that were unprecedented for that era. Debt financing worked well as a means to raise funds, particularly for railroads since they utilized their physical assets as collateral.
However, one obstacle lay in the unit banking system that existed in the United States at that time. Commercial banks were typically not allowed to have branches—that is, they could typically only have a single office—and were, therefore, much too small and undiversified to provide loans that could satisfy the significant needs of large corporations. Instead, large firms in the United States financed much of their growth by issuing bonds. Even early in American history, corporate bond markets became rather sizable. The total value of corporate bonds outstanding grew from $2 billion in 1880 to $15 billion in 1910, thereby representing approximately 50 percent of the GDP in 1910. Yet, unlike today, investors did not have access to a concrete assessment of the bonds’ credit risk in the form of a rating.
The Origin of Ratings for Corporate Bonds
Today, the ratings assigned to corporate bonds by credit rating agencies such as Moody’s or Standard and Poor’s are so central to credit markets that it is difficult to envision trading bonds without them. However, despite their significance, there is little research on how these credit ratings came to be and what impact they initially had on bond markets.
As bond markets grew in the nineteenth century, so did investors’ need to possess information on the bonds’ issuers. In the 1860s, Standard and Poor’s began producing manuals that compiled basic financial information and descriptions of the bonds outstanding of American railroad companies. Other competitors entered this market over time. One of them was John Moody. Moody had risen through the ranks of one of the most prominent investment banks of the era to become the head of research, which gave him recognition and credibility among investors and financiers. In 1900, he ventured out on his own and began publishing manuals similar to that of Poor’s. The Moody’s Manuals of Investments were received so well that Moody borrowed heavily to expand his business. But when a major financial panic brought the economy down in 1907, Moody found himself in financial trouble and had to sell his company to a competitor, who continued to publish the manuals under Moody’s name.
John Moody wanted to return to business, but he required a new business model. In April 1909, he published the first annual volume of Moody’s Analyses of Railroad Investments. Like all other manuals, this volume provided data that summarized the financial statements of every major railroad. But its major innovation was to apply a letter-grade rating system to classify the risk of railroad bonds, almost totaling 1,300. For each railroad, the manual presented a table listing all the railroad’s bonds by order of seniority. For each security, the table included information on various bond characteristics, such as liquidity and income available to pay interest to investors. The manual also provided a letter rating ranging from AAA to E. These letter groupings offered investors a simple summary measure of the quality of a bond that was easy to understand.
Letter ratings were not completely foreign to investors. Credit reporting agencies such as R.G. Dun & Co. and Bradstreet’s had rated the creditworthiness of individuals and firms since the mid-nineteenth century. Moody’s main advancement was to instead develop a methodology to rate the credit quality of specific bonds. This transformative innovation was quickly embraced by investors that had more limited access to information, such as retail investors and small financial institutions. In less than two decades, Moody’s competitors—Standard and Poor’s, Standard Statistics, and Fitch—incorporated ratings into their manuals. When the Office of the Comptroller of the Currency established rules in 1931 on the bonds that national banks could hold, it based those rules on credit ratings. This was the first major instance of ratings-based regulation. Since then, credit ratings have become increasingly central to financial regulations, financial contracts, and investment mandates.
Ratings Have Become Intertwined with Regulation
The centrality of ratings in today’s economy presents an important challenge to academics seeking to understand the effects that credit ratings have on markets and firms. Because ratings are intertwined with regulations and investment mandates, a potential change in a security’s rating could affect its demand, even if ratings were uninformative regarding the bond’s credit quality. Thus, in a modern setting, it is not possible to accurately identify whether credit ratings transmit information to markets.
Our work circumvents this limitation by analyzing the impact of the first-ever bond ratings. Since no ratings-based regulations existed, any effects of ratings can be solely attributable to a change in market participants’ risk expectations. To study whether the information transmitted by bond ratings affected markets, we hand-collected price and transaction data for more than five hundred railroad bonds before and after the publication of the Moody’s volume in April 1909.
Our Findings
- Information embedded in ratings affected bond prices. When Moody’s gave a railroad (or a specific railroad bond) a rating lower than what was expected by investors, the yields of those railroads’ securities increased by approximately 3–5 percent relative to other similar bonds. An increase in yields, which measure the rate of return paid to investors, suggests that investors perceived railroads bonds that received a worse-than-expected rating to be riskier.
- Categorizing risk in discrete buckets that were simple to understand was an effective means of transmitting information. Much of the information that Moody relied upon to construct its ratings was actually available to investors, albeit in a disaggregated manner, in the manuals that Standard and Poor’s and other competitors published at that time. But the availability of information relevant to determine bond risk does not imply that all investors understood how to utilize it. The immediate impact of Moody’s innovation suggests that discrete ratings may have simplified the interpretation of complex data that were available but difficult to process. By enabling credit risk information to be reflected in the prices of securities, ratings likely contributed to making bond markets in the United States more efficient.
- The introduction of credit ratings reduced information differences across investors. To study this question, we collected information from the New York Stock Exchange archives to estimate the bid-ask spread in bond markets before and after the first ratings manual was published. This spread measures the difference in the price at which market makers were willing to buy (i.e., bid price) and sell (i.e., ask price) bonds. A wider bid-ask spread reflects market makers’ concerns that they have an information disadvantage vis-à-vis buyers and sellers in the bond market. We find that spreads declined, relative to similar unrated bonds, for those bonds that were rated by Moody in 1909. This result suggests that the emergence of credit ratings alleviated a few investors’ concerns regarding having potentially less information regarding bond quality compared to more informed traders.
- Credit ratings may have been particularly useful for small investors. When examining the number of bonds bought and sold in each transaction, we found an increase in single-lot trades, which were more likely to have been utilized by individual traders. Thus, the introduction of credit ratings may have helped to broaden market access.
Policy Implications
Financial markets are more sophisticated today than they were in the beginning of the twentieth century, and investors rely on numerous sources of information to form their views on the risks and values of specific securities. Nonetheless, the strong reliance on credit rating agencies has reduced the production of information on bond risks by other entities. This indicates that credit ratings may continue to be a significant mechanism for information transmission in modern bond markets.
More generally, our work highlights the potential for innovations that increase transparency and information availability to enhance the functioning of financial markets, improve the allocation of capital in the economy, and contribute to economic growth. By broadening participation in financial markets, these innovations may also foster wealth accumulation and improve economic prosperity for a larger proportion of society.
Read the full paper here.
Carola Frydman is the Harold L. Stuart Professor of Finance at the Kellogg School of Management, Northwestern University.
This essay is part of the Long-Run Prosperity Research Brief Series. Research briefs highlight research that enhances our understanding of the factors that drive long-run economic growth and examine its policy implications.
