In this note we analyse the ratings information put out by credit rating agencies, including credit watch and outlook indicators, and see whether it can be used to gain an insight into future moves in composite bond ratings,¹ particularly in relation to potential downgrades. We believe that against a backdrop of higher inflation, rising interest rates, turbulence in the banking sector, and tightening bank lending standards, broad credit weakness cannot be ruled out during the remainder of 2023. How are composite bond ratings likely to evolve in the current environment, and why is it important to have a framework for predicting them?

The obvious and immediate answer is that investors care about future bond spread moves. Anticipating and predicting rating transitions can help to avoid downgrades, that lead to spread widening and can cause forced selling from some holders. Additionally, insurance portfolios that have solvency capital charges levied on them would potentially benefit from strategically exiting bonds that are predicted to have their composite rating downgraded over future months. In this case, the magnitude and timing of the predicted change matters as much as the direction of it.

We have found, via extensive empirical analysis of ratings datasets, that there are three specific indicators that can be derived from rating agency bond-level outputs that allow us to best predict future composite bond rating moves.² These are:

1. Rating momentum
2. Index methodology composite rating bias
3. Credit watch flag

Below, we assess how accurate each of these indicators have been at predicting the direction of future composite bond rating moves over the 1 to 12-month forecast horizon.³ It turns out that, whilst each of these measures are reasonably insightful on their own, their combination can be significantly more effective when it comes to predicting future changes in composite bond ratings. We call the combined metric the rating transition score and assess at the end of this note how it has performed historically.⁴

1. Rating momentum

The simple notion here is that bond rating moves exhibit momentum. Using daily historical bond ratings data since January 2016, we are able to test the extent to which changes in single agency bond ratings are likely to result in changes in composite bond ratings in the future. Figure 1 shows the summary hit rates,⁵ for both downgrades and upgrades, in both US investment grade and US high yield credit over future 1, 3, 6 and 12-month horizons. For example, within our extensive historical dataset, in US high yield, 21 per cent (26 per cent) of bonds that have had a recent single agency rating downgrade have subsequently had their composite rating downgraded over the following six (twelve) months.

It is clear from these results that rating momentum matters. 

2. Index methodology composite rating bias

The idea here is that the number of individual rating agencies contributing towards a given composite bond rating, and any alignment or otherwise disagreement between them, is helpful for predicting upcoming composite rating changes for that bond. Whilst noting whether a bond is already split-rated or not, we find that daily evolving single agency reporting events can give meaningful insights regarding its future composite bond rating changes. Figure 2 shows the summary hit rates for this indicator.

Judging by the magnitude of these hit rates, and comparing Figure 2 to Figure 1, we see that rating bias is potentially more important than rating momentum for predicting forthcoming composite bond rating downgrades and upgrades.

3. Credit watch flag

The final and most important concept to be aware of is that bonds with a credit watch flag have a greater likelihood of undergoing a near term rating transition (in the direction of the flag).⁶ Figure 3 shows the summary hit rates of this daily indicator versus future composite bond rating outcomes.

These results show that credit watch matters, even more so than rating momentum and rating bias particularly over the 1, 3 and 6-month horizons; 43% of US high yield names that were put on negative credit watch in our historical sample have had a composite bond rating downgrade over the subsequent 6 months.

Among all three indicators, it seems that the indicator was a more important driver in US high yield than in US investment grade.

Rating transition score

We combine our three daily indicators to produce a rating transition score for each bond and assess how accurately it has predicted changes in composite bond ratings. Figure 4 summarises the historical hit rates of the highest and lowest values of this score⁷ when used for forecasting composite bond rating upgrades and downgrades over future 3 and 12-month forecast horizons.

Focussing on the outcomes over the 12-month horizon, we see that the resulting upgrade and downgrade probabilities associated with extreme scores are reasonably strong, falling between 50% and 65%. To put these numbers into context, we compared these transition rates with those in US investment grade and high yield benchmarks.⁸

For example, whereas, empirically, there is a 7% chance that an investment grade index’s constituents will be downgraded over a 12-month horizon, you can actually improve portfolio outcomes by steering the allocation away from bonds with rating transition scores of -2 or lower (which each have a 51% chance of being downgraded) towards bonds with rating transition scores of +2 or higher (which each have a 62% chance of being upgraded). Analogously, in high yield credit, there is an 18% chance that high yield index constituents will be downgraded over a 12-month horizon. Likewise, you can improve portfolio outcomes by steering the allocation away from bonds with rating transition scores of -2 or lower (which each have a 56% chance of being downgraded) towards bonds with rating transition scores of +2 or higher (which each have a 65% chance of being upgraded).

Conclusion

We have developed a framework for constructing rating transition scores to predict composite bond rating events. The approach capitalises on momentum in bond ratings, published rating agency credit watch flags and the replication of index composite rating methodologies. The rating transition scores are produced at the bond level and, as such, can be used within portfolio construction and risk management contexts for avoiding bonds that are at increased risk being downgraded. Equivalently, the output can be used to identify and get ahead of future upgrade events. Other direct applications include the anticipation of capital charge evolution in insurance portfolios and the construction of forward-looking rating transition matrices, including multiple rating notch forecasts.

¹ Bond index providers commonly incorporate the bond ratings from the three main rating agencies into aggregate rating measures called composite credit ratings, which they use as part of their index membership criteria.
² The historical analysis was conducted using the US investment grade corporate and US high yield corporate bond universes. More generally, we have access to daily agency ratings, and their associated credit watch and outlook metrics, for all global corporate bonds and issuers. The historical analysis was conducted using over seven years of data.
³ We have also conducted other, more detailed, studies that assess not just the directional accuracy of these predictors but also their ability to forecast the magnitude of future composite bond rating changes. We will look to utilise these results in future blogs.
⁴ The Barclays Credit Research team has conducted a related study in a paper titled, “Ratings Recidivism: Downgrade Momentum in Corporate Credit”, 10^th March 2023. The paper focuses exclusively on rating momentum trends and credit watch lists.
⁵ We define hit rate as an empirical measure of how often, within our historical dataset, composite rating change predictions got materialised over given future time periods.
⁶ We tested both the credit watch and outlook indicators put out by the main rating agencies. Whilst our empirical tests have determined credit watch to be a useful predictor (of composite bond ratings), they have not found this to be the case for outlook. We also note here that less than half of all agency rating changes historically were preceded by a credit watch indicator.
⁷ i.e. +2 or better and -2 or worse.
⁸ Analysis conducted using index constituent composite rating changes during the period 2016-2022.

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