The Added Value of Rating Outlooks and Rating Reviews to Corporate Bond Ratings
|A prime objective set by credit rating agencies is to achieve stability of their corporate bond ratings by a rating through-the-cycle methodology. However rating stability is at the expense of rating timeliness and default prediction performance. To mitigate this tension between stability and accuracy, agencies publish outlooks – rating Outlooks and rating Reviews (Watchlist) – in addition to corporate bond ratings. Outlooks provide an indication of the direction and timing of likely rating changes in the future. In this study we quantify the added value of outlooks to corporate bond ratings and investigate to what extent outlooks are able to compensate for the disadvantages of rating stability. Results show that outlooks do indeed partially close the gap between the agencies’ through-the-cycle perspective and the investor’s point-in-time perspective. After adjusting ratings by their outlooks default prediction performance does improve, but only slightly, especially for short prediction horizons. Default prediction performance and point-in-time characteristics of adjusted ratings could be enhanced even further if outlooks become more accurate measures of credit risk. We conclude that accuracy in credit risk information signaled by outlooks can be improved most likely by standardizing credit risk information in the outlook scale. Credit risk dispersion in the outlook scale could be enhanced by a factor two. Perhaps, as outlooks are not intended to quantify credit risk information explicitly, agencies have not standardized credit risk information in the outlook assignment process. We also considered the impact of the explicit timing objective of outlooks which to some degree overrides credit risk information signaled by outlooks. From a pure credit risk perspective the timing objective of outlooks shortens durations for rating Reviews, lengthens durations for rating Outlooks and partially circumvents the use of rating Outlooks as “intermediate” states between Stable Outlooks and rating Reviews. However this specific outlook migration policy has little effect on credit risk accuracy in outlooks.