Rating Transition and Default Rates Conditioned on Outlooks

Abstract

This report documents global corporate credit rating transition and default rates during the 1995-2003 period conditional on the full information in Moody's published credit opinions, which, in addition to the current credit rating, include prior rating actions and current rating outlooks and reviews. The primary findings of this study are:

• Moody's rating system management practices attempt to limit rating reversals and dampen rating change volatility and, as a consequence, different issuers carrying the same rating may have different risks of rating migration and default.

• As noted in Moody's prior research dating back to 1993, recently downgraded issuers have a greater likelihood of future rating downgrades and default than do recently upgraded issuers. For example, obligors downgraded in the past twelve months are eight times more likely to be downgraded than upgraded in the next year. Downgraded issuers are eleven times more likely to default over one year than upgraded issuers.

• Moody's rating outlooks and reviews are used to signal the likely direction and timing of future rating actions and the evolution of default risk. For example, at a one-year time horizon, issuers with negative outlooks are seven times more likely to be downgraded than upgraded; issuers with positive outlooks are nearly twice as likely to be upgraded as downgraded; and issuers with stable outlooks have the highest probability of no rating change. Default rates within a given rating category also vary systematically by outlook status. For example, obligors with positive outlooks are, on average, nine times less likely to default over one year than obligors with negative outlooks.

• Rating history and outlook status are each highly predictive of future rating changes, but rating history appears to have little additional impact on rating transitions once outlook status is controlled for. The likelihood of a rating transition over a given time horizon is nearly constant for a given rating and outlook, regardless of rating changes that occurred in the last year.

• Rating history and rating outlooks have independent effects on the conditional likelihood of default. At a one-year risk horizon, a credit rating downgrade signals a higher risk of default, holding outlook status constant. Over a longer holding period (three years), rating history has a weaker incremental impact on the probability of default.

• The historical performance of Moody's ratings as predictors of default is enhanced when measured on a conditional basis compared to an unconditional basis. Applying a one-notch adjustment to credit ratings for outlooks and a two-notch adjustment for rating reviews raised the historical 3-year-horizon accuracy ratio (AR) to 70.9%, compared to 64.9% on an unconditional basis. More aggressive adjustments would increased the AR only a small additional amount (0.3%) and may not be appropriate in other sample periods. Similarly, additional adjustments for rating history raised the historical accuracy ratio by only 0.2%.

Keywords: credit ratings, defaults, rating transitions, rating migrations