Credit Ratings and Investments

We study the impact of potentially inflated credit ratings in bond markets using experimental coordination games. Theoretical models featuring a feedback effect between capital markets and the real economy suggest that inflated ratings can have both positive and negative effects. Comparing markets with and without a credit rating agency, we find that ratings significantly influence investor behavior and capital allocation to firms. While we find evidence for both positive and negative real effects of potentially inflated ratings, the presence of a rating has an overall positive effect. We examine the mechanisms underlying these real effects and find that they operate mainly through investors’ beliefs about others’ behavior, and less so through beliefs about the firm’s fundamentals. This paper was accepted by Camelia Kuhnen, finance. Funding: A. Bayona acknowledges financial support from the Spanish Ministry of Science, Innovation and Universities and Agencia Nacional de Investigación [Grants ID2021-123748NB-I00 and PID2024-156339NA-I00], and Universitat Ramon Llull [Grant 2021-URL-Proj-068]. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2024.06886 .