The Bond Market Knows More than the Credit Rating Agencies

Larry SwedroeInvestors should rely on the wisdom of crowds as expressed through bond yields, not credit rating agencies, to judge fixed-income credit risk.

The wisdom of crowds refers to the idea that large groups of people are collectively smarter than individual experts. As James Surowiecki explained in his 2004 book, The Wisdom of Crowds, for crowds to be wise, they must be characterized by a diversity of opinions, and each person’s opinion should be independent and free from the influence of others. When that is the case, economic theory hypothesizes that markets should be efficient – share prices reflect all information, and consistent alpha generation is extremely difficult. On the other hand, an ill-informed crowd can lead to adverse outcomes (like bubbles and their eventual bursting).

Is the wisdom of the crowd of corporate bond investors (who set prices through their trades) more accurate than the wisdom of the credit rating agencies (Moody’s, S&P and Fitch)? The corporate bond market is dominated by sophisticated institutional investors (mutual funds, ETFs, banks, insurance companies, sovereign wealth funds, etc.) who typically conduct their own research in addition to credit ratings for investment decisions. A 2017 Invesco report showed that individuals directly own only about 5% of corporate bonds. Miles Livingston, Yao Zheng and Lei Zhou, authors of the study, “Do Bond Investors Know Better than the Credit Rating Agencies?,” published in the Spring 2023 issue of The Journal of Fixed Income, investigated whether the experts (the rating agencies) or the wisdom of the crowd provided better estimates of credit risk.