Do Bond Investors Know Better than the Credit Rating Agencies?

This article examines the ability of bond investors to detect and adjust for potentially biased credit ratings. It finds evidence that investors require higher yield spreads on bonds with upwardly biased ratings, and that unusual yield spreads have predictive power for rating changes and defaults within 3 years of bond issuance. Bonds with unusually high yield spreads are more (less) likely to be downgraded (upgraded). Furthermore, 3-year default rates for those bonds are 2.5 times those of bonds with unusually low yield spreads. These findings suggest that yield spread could be a better measure of credit risk than ratings.