Estimating Default Probabilities of Corporate Bonds over Various Investment Horizons

Abstract

In advance of forthcoming regulatory changes, commercial banks have developed sophisticated internal credit models that consider the risk of their counterparties. Even though these models suffer from high Type II errors—false forecasts of default—they tend to be quite accurate in bankruptcy prediction. Although external credit rating agencies excel at assessing the initial rating of a corporate bond, they are slow to change their ratings in light of new information. The flexibility and ease of use of a well-known internal credit model, first developed in the 1960s, and the extensive default histories of the external rating agencies can be combined to predict the probability of default over investment horizons stretching from 1 year to 10 years.