The importance and subtlety of credit rating migration

Bond ratings are usually first assigned by rating agencies to public debt at the time of issuance and are periodically reviewed by the rating companies. If deemed warranted, changes in ratings are assigned after the review. A change in a rating reflects the agency's assessment that the company's credit quality has improved (upgrade) or deteriorated (downgrade). A coincident effect, in some proximity to the date of the rating change, is a change in the price of the issue. This article reports on an in-depth investigation of the expected ratings changes (drift) over time. Our analysis compares rating changes from the two major agencies, Moody's and S&P, over the period 1970-1996. For the first time, results from several studies which have documented and analyzed these data patterns are contrasted. Depending upon which study one uses, the results and implications can be very different. We expect that the findings will have implications for such diverse practitioners as bond investors who concentrate on any or all segments of the corporate bond market, eg., high yield bond and "crossover" investors, mark-to-market analysts, and traders in the new and growing market for credit-risk-derivatives and for the many analysts who properly view that credit quality assessment involves the entire spectrum of possible outcomes, not just default. A follow-up study will analyze, in greater depth, two critical characteristics of the rating drift phenomenon. These are unexpected, as well as expected, rating migration patterns and also the implied impact on the price of the fixed income instrument. (C) 1998 Published by Elsevier Science B.V. All rights reserved.