Can Rating Agencies Look Through the Cycle?
by Gunter Löffler of the University of Ulm
Abstract: Rating agencies claim to look through the cycle when assigning corporate credit ratings, which entails that they are able to separate trend components of default risk from transitory ones. To test whether agencies possess this competence, I take market-based estimates of one-year default probabilities of corporate bond issuers and estimate their long-run trend using the Hodrick-Prescott filter, local regression, or centered moving averages. I find that ratings help identify the current split into trend and cycle. Their stability is similar to the one of hypothetical ratings based on trends. Since the examined trends are forward-looking, agency ratings exhibit important characteristics one would expect from ratings that see through the cycle.
Keywords: credit ratings, through-the-cycle, Hodrick-Prescott filter.