Risks in Relying on Ratings from Credit Rating Agencies

Investors overwhelmingly believe that credit rating agencies do a good job assessing credit risk. In fact, with a few exceptions (e.g., too high ratings on US subprime mortgage-backed securities issued in the mid-2000s that turned out to be much riskier than expected), their ratings have proved to be quite accurate in the measurement of default risk.

The highest-rated bonds have extremely low default rates. On the other hand, the lower the rating, the higher the annual rate of default. Bonds rated CCC have a 20% chance of default each year, while bonds rated BBB have a default probability of only 0.18%.

Limitations of Rating Agencies

The following are the limitations and risks to relying on credit rating agency ratings:

Credit ratings can change over time

Over a long time, credit ratings can shift. A bond with a BBB with only a 0.18% probability of default could be downgraded to CCC and, therefore, have a 20% chance of default. However, the higher the credit rating, the higher the rating stability, meaning there is a lower probability that the bond’s rating will shift.

Creditworthiness fluctuates over time. Bond investors should, therefore, not assume that credit rating will remain constant throughout the entire holding period.

Credit ratings tend to lag the market pricing of credit risk

Bond prices and spreads frequently move more swiftly than rating agencies change their ratings. Bond prices could move down sharply well before a rating agency downgrades its credit rating.

Rating agencies may make mistakes

Examples include mis-ratings of US companies, Enron and WorldCom, and European issuer, Parmalat. In these instances, rating agencies could not see the accounting fraud.

Some risks are difficult to capture

Litigation risks, for instance, may affect tobacco or energy, or chemical companies. Also, some unpredictable events such as earthquakes or tsunamis may have severe effects on credit quality.

Question

Which of the following is least likely a limitation of relying on credit rating agency ratings?

1. Some risks are very hard to identify.
2. Credit ratings tend to lag the market pricing.
3. Credit ratings have historically been quite inaccurate.

Solution

The correct answer is C.

Investors overwhelmingly believe that credit rating agencies do a good job assessing credit risk. In fact, with a few exceptions, their ratings have proved to be quite accurate in the measurement of default risk.

There are 4 major limitations:

• credit ratings are can change over time;
• credit ratings tend to lag the market (Option B);
• rating agencies make mistakes; and
• some risks are hard to capture (Option A).