By Edward I. Altman
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Additional resources for Corporate Bond Rating Drift: An Examination of Credit Quality Rating Changes over Time
The MS model, in contrast to other models, had a preponderance of positive estimate errors. The estimate errors from the MS model are positive for all five rating categories for the 10-year period. This indicates that the "stayers" over the long term were actually fewer than those estimated by the MS model. The only consistently negative MS estimated error was for the AAA category, at least through seven years. Similar conclusions are observed if the analysis is performed for the periods of 1970 to 1979 and 1980 to 1989, as shown in Table 11.
The MS model also outperformed the historical model in most cases, although the length of transition horizon in which the estimation was applied decreased from up to five years in 1982 and 1983 to just two years in 1985. Table 18 presents the results in Table 17 according to the time of transition horizon. The MKV-S and MKV-NS outperformed the historical models for all the transition horizons examined (up to seven years). The poor performance of the three stochastic models in comparison with the historical model in recent years was attributable to the drastic deterioration in credit quality of issuers and their consequent downratings (see Lucas and Lonski 1991).
Clearly, the net return to investors in this class, assuming no change in interest rates during that five years, will be lower than the initial yield expected by investors who did not consider rating changes. In the case of a BBB-rated bond, however, the tendency to be upgraded appears to be greater than that of being downgraded during the first five years of its life, so the net return should improve. The amount of the upgrade or downgrade is also relevant to the effect of the change on returns.