Analyzing the Tradeoff between Ratings Accuracy and Stability

Abstract

Many market participants, including investors, issuers, and regulators, have a strong preference for corporate bond ratings that are not only accurate but also stable. They want ratings to reflect enduring changes in credit risk, because rating changes can have real consequences - due primarily to ratings-based portfolio governance rules and rating triggers - that are costly to reverse. Market participants, moreover, do not want ratings that simply track market-based measures of credit risk. Rather, ratings should reflect independent analytical judgments that provide a counterpoint to the often volatile marketprice-based assessments. It may be possible, however, to increase the short-term predictive content of our rating system by increasing the responsiveness of ratings to new information about credit fundamentals. In other words, it may be possible to increase ratings accuracy while reducing, perhaps substantially, ratings stability. In the sections that follow, we discuss the potential accuracy and stability attributes of different rating management systems. We then illustrate the potential tradeoff by comparing the combinations of the accuracy and stability associated with the many different "rating systems" that can be derived by applying various filters to Moody's-KMV's expected default frequencies ("EDFTM's). The performance of Moody's traditional ratings - both adjusted and unadjusted for rating reviews and outlooks - is then compared to the performance of the various filtered versions of EDF-implied ratings.

Keywords: credit ratings, accuracy, stability