The Impact of Downward Rating Momentum
34 Pages Posted: 4 Jan 2007 Last revised: 6 Apr 2010
Date Written: November 12, 2007
Rating downgrades are known to make subsequent downgrades more likely. We analyze the impact of this “downward momentum” on credit portfolio risk and bond portfolio management. Using Standard&Poor’s ratings from 1996 to 2005, we apply a novel approach to estimate a transition matrix that is sensitive to previous downgrades and contrast it with an insensitive benchmark matrix. First, we find that, under representative economic conditions, investors who rely on insensitive transition matrices underestimate the momentum-sensitive Value-at-Risk (VaR), on average, by 107 basis points. Second, we show that bond portfolio managers should use our downgrade-sensitive probabilities of default as they seem to be better calibrated than momentum-insensitive estimates.
Keywords: Rating drift, Downward momentum, Credit portfolio risk, Value-at-Risk, Bond portfolio management, Calibration
JEL Classification: C41, G24, G32
Suggested Citation: Suggested Citation