Rating Migrations

The bond rating is one of the most important indicators of a corporation’s credit quality and therefore its default probability. It was first developed by Moody’s in 1914 and by Poor’s Corporation in 1922 and it is generally assigned by external agencies to publicly traded debts (Altman and Kao, 1992). Apart from the external ratings by independent rating agencies, there are internal ratings by banks and other financial institutions (Basel Committee on Banking Supervision, 2006). External rating data by agencies are available for many years, in contrast to internal ratings. Their short history in most cases does not exceed 5–10 years. Both types of ratings are usually recorded on an ordinal scale and labeled alphabetically or numerically. for the construction of a rating system see Crouhy, Galai and Mark (2001).

A change in a rating reflects the assessment that the company’s credit quality has improved (upgrade) or deteriorated (downgrade). Analyzing these rating migrations including default is one of the preliminaries for credit risk models in order to measure future credit loss. In such models, the matrix of rating transition probabilities, the so called transition matrix, plays a crucial role. It allows the calculation of the joint distribution of future ratings for borrowers in a portfolio (Gupton, Finger and Bhatia, 1997). An element of a transition matrix gives the probability that an obligor with a certain initial rating migrates to another rating by the risk horizon. For the econometric analysis of transition data see Lancaster (1990).