Rating labels and style investing: Evidence from Moody's rating recalibration

Xinyuan Tao and Chunchi Wu

Financial Management, 2021, vol. 50, issue 4, 1047-1084

Abstract: This paper investigates the role of style investing in comovement and return predictability. Using Moody's rating recalibration event to isolate the style effect, we find that changes in rating labels have powerful effects on comovement of municipal bond returns, trading activity, and volatility. Volatility‐based comovement adds to the return comovement. Rating style investing induces return predictability and affects return formation, which interacts with investor sentiment. Shifts in the rating label drive these results through correlated trading activities, and the effects are reinforced by behavioral biases and trading frictions.

Date: 2021
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