Investors overwhelmingly believe that credit rating agencies do a good job assessing credit risk. In fact, with a few exceptions (i.e., 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 as a measure 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
There are limitations and risks, however, to relying on credit rating agency ratings:
Credit ratings can change over time
Over a long time period, credit ratings can migrate. A bond with a BBB with only a 0.18% probability of default could be downgraded to CCC and therefore now has 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 migrate.
Creditworthiness can and does change up or down over time, and bond investors should not assume credit rating to remain the same throughout the entire holding period.
Credit ratings tend to lag the market pricing of credit risk
Bond prices and spreads frequently move more quickly 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.
Which of the following is least likely a limitation on relying on credit rating agency ratings?
A. Some risks are very hard to identify
B. Credit ratings tend to lag the market pricing
C. Credit ratings have historically been quite inaccurate
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 as a measure 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
- Some risks are hard to capture (Option A)
Reading 55 LOS 55e:
Explain risks in relying on ratings from credit rating agencies