The Bond Market Knows More than the Credit Rating Agencies

They noted: “As a result of the issuer-pay model [the issuer pays for the rating], CRAs [credit rating agencies] have incentives to lower rating standards and inflate ratings to attract bond issuers and maximize their profits at the expense of rating quality and bond investors.” They hypothesized: “The unusual at-issuance yield spread, or deviation from the model-implied yield spread based on credit ratings and other bond characteristics, is an indication of investors’ assessment of credit rating accuracy and potential bias. The idea is simple: if investors believe a bond rating is accurate and unbiased, they will price the bond close to other same-rated bonds with similar characteristics and the unusual yield spread should be small. On the other hand, if the rating is believed to be upwardly (downwardly) biased, investors will adjust for the bias by setting the bond price lower (higher) than those of other same-rated bonds and, consequently, the unusual yield spread should be high (low).”

To test if investors can correctly assess the accuracy of credit ratings, they examined unusual yield spreads’ relations with future rating changes and default rates. The authors explained: “If unusual yield spread is a good measure of rating accuracy, it would have predictive power for future rating changes: bonds with unusually high (low) yield spreads are more (less) likely to be downgraded and less (more) likely to be upgraded.” They added: “If bond investors are correct in their assessment of the potential rating bias, bonds with unusually high (low) yield spreads are expected to have higher (lower) default rates than other same-rated bonds.” Their data sample covered more than 6,000 U.S. domestic corporate bonds issued between 1996 and 2015. Ratings were from S&P and Moody’s. Here is a summary of their key findings:

• Credit ratings on bonds with unusually high at-issuance yield spreads were higher than model-implied or expected ratings based on issuers’ financial fundamentals and other characteristics – bond investors could detect upwardly biased ratings and require higher offering yields to adjust for rating bias.

• Unusual yield spreads had strong predictive power for rating changes and bond defaults within three years of initial issuance – bonds with unusually high yield spreads were much more likely to be downgraded and default than bonds with unusually low yield spreads.

The authors concluded: “Our findings suggest that bond yield spreads are indeed more informative than credit ratings and can potentially serve as a better measure of credit risk for financial regulations. … The findings in the paper lend support to proposals to replace credit ratings in financial regulations with market-based measures of credit risk.” They noted that their findings were consistent with those of the authors of the 2019 study, “Ratings versus Spreads as Indicators of Price Risk,” who found that bond yield spreads have greater explanatory power for future price volatility than credit ratings.

Investor takeaways

If investors believe the rating on a particular bond is inflated from a true BBB to an A, they will price the bond at a yield similar level to other BBB-rated bonds (significantly higher than other A-rated bonds), providing investors with a signal of higher default risks instead of an opportunity to capture higher yields. Bond fund investors should thus be cautious: To capture more assets, fund managers could increase the reported yield of their fund by buying the bonds with the highest yield for a given credit rating. Livingston, Zheng and Zhou showed that the resulting higher yield is not a free lunch. Instead, it indicates incremental credit risk—risk the investor might want to avoid. In fact, institutional investors even may be prohibited from buying the bond by their charter had the bond rating reflected the wisdom of the crowd.

In its bond funds, Dimensional has always relied on the market yield, not the credit rating, to determine if a bond meets its credit criteria. If its fund were restricted to buying bonds with the credit risk of BBB-rated bonds, and a BBB-rated bond was yielding the same as a bond rated BB, Dimensional would not purchase it. In building individual bond portfolios for our clients, Buckingham Strategic Wealth follows the same principle.

Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners.

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