Correlation between Credit Ratings and Default Frequencies
Diane Vazza, a Managing Director at Standard & Poor’s Ratings Services, discusses the findings of the rating agency’s latest Annual Global Corporate Default Study and Rating Transitions.
The year to-date count of defaults by S&P-rated corporates now stands at 68 globally – well more than triple the 19 defaults that occurred during the same period in 2008. Meanwhile, by region, the US has maintained its lead, with 54 defaulted issuers so far this year.
Furthermore – as Standard & Poor’s latest Global Corporate Default Update, published 6th April 2009, also reports – 35% of defaults this year are outside of the US. This contrasts with 5% of defaults this time in 2008 – illustrating just how global the current economic and credit pressures have become.
Default rates in the spectulative- grade rating categories are well below the record levels seen in prior cycles.
In addition, Standard & Poor’s has also recently published its Annual Global Corporate Default Study and Rating Transitions for 2008. This study charts the dramatic deterioration in corporate credit quality that occurred in 2008, as well as detailing the year’s default occurrences which picked up sharply in each progressive quarter of the year, yielding a final annual tally of 125 defaults globally – a figure which contrasts starkly with the ultra-lows seen a year earlier.
Examining these default rates is valuable because all of Standard & Poor’s default studies have found a clear correlation between ratings and observed default frequencies: the higher the rating, the lower the observed frequency of default, and vice versa. In fact even in 2008, amid high turbulence, the ability of corporate ratings to serve as an effective measure of relative risk has remained intact.
Transition studies confirm stability of higher ratings
Many default studies, including this one, also look at transition rates, which gauge the degree to which ratings change – either up or down – over a particular time.
Indeed, transition studies have repeatedly confirmed that higher ratings tend to be more stable and that speculative-grade debt generally experiences more rating volatility.
Analysis of transition rates over the four quarters ending December 2008 suggests that ratings behaviour continues to exhibit consistency with long-term trends, showing a clear negative correspondence between credit rating and default probability. Indeed, Table 1 demonstrates that investment-grade-rated issuers – globally – tend to exhibit greater credit stability (as measured by the frequency of rating transition) than their speculative-grade counterparts.
For instance, 87.59% of issuers rated ‘A’ at the beginning as of January 1, 2008, were still rated ‘A’ by December 31, 2008, whereas the comparable share for an issuer rated ‘B’ was only 73.16%. The same relationship holds even when the transition rates are analysed separately for the US, Europe, or the emerging markets.
Notably, some unusually large transitions from ‘AAA’ to ‘B’ and ‘CCC’ observed in the table are attributable to pronounced deterioration among some monoline insurers, notably FGIC Corp, FGIC UK Ltd., and CIFG Guaranty.