Corporate Bond Rating Drift: An Examination of Credit by Edward I. Altman

By Edward I. Altman

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The parameters of three stochastic models were estimated from successive one-step transition matrixes, P(k,k+ 1). These parameters and the properties of the models were then used to estimate the transition probabilities during the next several years for all the bonds (new or seasoned) existing at the end of 1982. Thus, for a five-year transition horizon, we estimated P(0,5), P(1,6), P(2,7), P(3, 8), . ,P(T, T+5). These estimated five-year transition matrixes were then compared with the actual transition matrixes observed from January 1983 to December 1987.

Although we concentrate on postissue experience, our stochastic model does consider the prior experience of an issue in order to estimate future rating changes. The Moody's study is a descriptive report with little interpretive commentary, and no attempt was made to model the rating change experience. Our study includes extensive modeling of rating drift. Because we examine the postissuance period and Moody's does not, the two studies' results are not exactly comparable. Nevertheless, the descriptive differences in results are not major.

The aggregate chi-square has w(w- 1) degrees of freedom. Further, by examining the chi-square measures (individual or aggregate) of Modeling Bond Rating Dr$t TABLE 13. Estimate Errors of Rating Downgrade Percentages 1970-89 1970-79 1980-89 Age and Rating MKV-S MKV-NS MS MKVS MKV-NS MS MKV-S MKV-NS MS 3 Years AAA AA A BBB 5 Years AAA AA A BBB 7 Years AAA AA A BBB 10 Years AAA AA A BBB Note: MKV-S = Stationary Markov chains, MKV-NS MS = Mover-Stayer Model. = Nonstationary Markov chains, and different time periods into the future, it is possible to determine the approximate upper bound of the time period for which the forecasted transition is reasonably reliable.

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