Do Credit Ratings Move Toward The Market, Or Vice Versa?

Abstract

There are many different gauges of credit risk that investors can use to inform their decisions. Credit rating agencies have produced measures of credit risk for many decades, but financial markets also offer a guide to these risks. The authors examine the behavior of ratings relative to market signals on credit risk. In particular, the authors examine what happens when ratings and market signals differ, in terms of any subsequent convergence (or not). They find that, on average, market signals move more frequently toward ratings than vice versa. In terms of the magnitude of these movements, however, the picture is less clear. When market signals suggest lower credit risk than ratings do, they tend to close more of the gap; when ratings are higher than market signals, however, sometimes ratings close the gap more.