Do Credit Ratings Accurately Predict Risk of Default?

You’ve all heard about S&P downgrading US debt from AAA to AA+, and how this has affected the markets.

This made me wonder: how reliable have S&P’s ratings on long-term debt really been historically?  They’ve been doing it for a long time, so presumably if they were really good at it, they would boast about their track record. Indeed, S&P would compete the other ratings agencies (Fitch, Moody’s) based on the accuracy of their predictions.

It’s well-known that S&P and the other ratings agencies were spectacularly wrong in the case of collateralized debt obligations, much of which rated as AAA. I wouldn’t be at all surprised if they’ve been wrong in less spectacular ways much of the time.

Presumably each credit rating corresponds to a probability of payout, and given historical data, one could check how well the ratings matched reality.   For example, if I were to look at all US-dollar denominated 10-year bonds issued in the year 2000, for which S&P had a rating at the time of issue, by 2010 one could tally up how they performed.

For simplicity, the performance of a particular bond could be expressed as a binary (yes/no) answer to a simple question: did the borrower pay the bond-holders the stipulated interest and principal?

If the ratings were worth anything, the probability of “yes” should be highest for the AAA bonds, and progressively lower for lower ratings (AA+, AA, etc. all the way to C).

Furthermore, the probabilities should be fairly stable over time; for example the probability of default for a 10-year bond rated BBB at issue in 1970 should be the same as that for a 10-year bond rated BBB in 2000. Certainly economic conditions in the 1970s were different from those in the 2000s, and some things are difficult to predict (e.g. the oil crisis in the 1970s, 9-11 in 2001), but the ratings guys are supposedly experts, so their ratings should be robust – or at least better than those of astrologists.

Does anyone know whether such back checking of ratings has been done? If it has been done, the information certainly sure isn’t easy to find.

Back to that recent downgrade: if I bought a 10-yr AAA US bond issued five years ago, according to S&P it’s now AA+… which sort of means the AAA rating wasn’t really correct to begin with. A prediction for long-term creditworthiness isn’t worth much if you’re allowed to change that prediction part-way!


About Gerry Beauregard

I'm a Singapore-based Canadian software engineer, inventor, musician, and occasional triathlete. My current work and projects mainly involve audio technology for the web and iOS. I'm the author of AudioStretch, an audio time-stretching/pitch-shifting app for musicians. Past jobs have included writing speech recognition software for Apple, creating automatic video editing software for muvee, and designing ASICs for Nortel. I hold a Bachelor of Applied Science (Electrical Engineering) from Queen's University and a Master of Arts in Electroacoustic Music from Dartmouth College.
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