The Impact of the Rating Agencies' Through-the-cycle Methodology on Rating Dynamics

Abstract

Surveys on the use of agency credit ratings reveal that some investors believe that credit-rating agencies are relatively slow in adjusting their ratings. A well-accepted explanation for this perception on rating timeliness is the through-the-cycle methodology that agencies use. Through-the-cycle ratings are intended to measure default risk over long investment horizons and to respond only to changes in the permanent component of credit quality. A second aspect of the through-the-cycle methodology is the prudent migration policy. In a benchmark study with a financial ratio-based credit-scoring models – an agency-rating prediction model and default-prediction models with various time horizons – we confirm the exclusive focus of agencies on the permanent component of credit quality and we model and quantify the agencies’ prudent migration policy. A rating migration is triggered only when the rating predicted by the agency-rating prediction model differs by at least a threshold level of 1.8 notch steps from the actual agency rating. If triggered, ratings are only partly adjusted by 70 per cent at the downside and 60 per cent at the upside. From a 1-year point-in-time perspective, weighting temporary fluctuations in credit quality, the through-the-cycle methodology lowers the rating-migration probability by a factor of 3.5. Both aspects of the through-the-cycle methodology contribute equally to this factor. The partial adjustment of ratings lowers the rating-reversal probabilities on short term and introduces rating drift, the known serial correlation in agency-rating migrations.

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