The Information Value of Bond Ratings

Abstract

We examine whether bond ratings contain pricing relevant information, that is unavailable to investors from other sources, by focusing on investor reaction to rating changes that were not accompanied by any economic fundamental event - Moody's refinement of its rating system. This refinement was not accompanied by any fundamental change in the issuers' risks, was not proceeded by any announcement, and was carried simultaneously for all bonds. We find that rating information is valuable: (1) Prior to the release of Moody's fine rating information, bond yield spreads were not perfectly correlated with the fine rating information Moody had but hadn't made public; (2) Following Moody's announcement of the fine ratings, bond prices adjusted to the new information; and (3) The prices of the stocks of the bond issuers also reacted to Moody's new information. In accordance with the observation that stock value is a convex function of the firm's value, the stock price reaction was in the opposite direction to that of the bond prices. Lastly, the total-firm value was not significantly affected by the announcement of Moody's fine ratings. We interpret this to mean that information conveyed by rating changes about default risk is largely diversifiable.

JEL Classification: G12, G14