Rating Transitions and Defaults Conditional on Watchlist, Outlook and Rating History
24 Pages Posted: 2 Jul 2004
Date Written: February 2004
This report documents the historical rating transition and default rates of Moody's-rated debt issuers conditional on lagged rating actions, rating outlooks, and rating reviews. We primarily seek to answer three questions, each addressed in its own section of this special comment. First, we ask how different are rating transition and default rates conditional on rating history and outlook/Watchlist status, where each is considered in isolation? Second, does rating outlook/Watchlist status fully summarize transition and default risk within each rating category? Or does rating transition and default risk still depend in part on rating history once conditioned on outlooks and reviews? Finally, we investigate whether the information content of Moody's credit ratings is increased by recognizing the information contained in rating outlooks and reviews. The study finds that rating outlooks and Watchlist assignments greatly enhance the predictive power of credit ratings. The accuracy ratio - a commonly used metric for evaluating the ability of a rating system to predict defaults - was found to be greatly improved by conditioning credit ratings on rating outlooks and reviews. Adjusting credit ratings on review for upgrade or downgrade by two notches and adjusting ratings for outlook status by one rating notch raised the accuracy ratio to 70.9% from 64.8% unconditionally. More aggressive adjustments for outlooks and reviews and additional adjustments for rating history had much more limited effects, increasing the accuracy ratio by only an additional 0.5%.
Keywords: default, credit ratings, serial correlation, outlooks
JEL Classification: G10, G30, G33
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