Are the Standards Too Poor? An Empirical Analysis of the Timeliness and Predictability of Credit Rating Changes

Abstract

In this paper we investigate the dynamics of credit rating changes by Standard & Poor's (S&P) for all 583 companies that were included in the S&P 500 index between July 1998 and June 2003. Our analysis shows that KMV Corporation, a 'new' entrant to the credit rating industry that uses a quantitatively oriented, market-based approach to credit risk measurement, provides a significantly timelier insight into companies' credit quality changes than the qualitatively oriented, accounting-based approaches used by S&P. Based on a sample of 690 rating changes reported by S&P during the sample period, we show that 75% of the S&P rating changes are significantly anticipated by KMV more than a year in advance. Furthermore, we test for the predictability of S&P's rating changes. We show that KMV's Expected Default Frequencies possess considerable predictive power to forecast future rating changes by S&P.