Ratings versus market-based measures of default risk in portfolio governance

This paper assesses whether ratings or market-based credit risk measures are more suitable forformulating portfolio governance rules. Such rules, which consist of buy and sell restrictions,are commonly used in investment management. Based on data from 1983 to 2002, it is notevident that one of the two measures is superior. The relative power of the two measures inpredicting defaults depend on the investor’s investment horizon and risk appetite. The resultssupport the agencies' claim that their policy of reducing rating volatility, which builds on thethough-the-cycle approach and the avoidance of frequent rating reversals, is beneficial tobond investors. The results also suggest that widely used statistical measures of rating qualitymay be insufficient to judge the economic value of rating information in specific contexts.