Can rating agencies look through the cycle?
Published online: 8 April 2012
Ó Springer Science+Business Media, LLC 2012
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 1-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. In addition, rating stability is similar to the one of
hypothetical ratings based on long-term trends. The results are robust to the use of different ﬁlter
techniques. They are conﬁrmed by a model-free analysis, which shows that ratings predict future
changes in market-based default probability estimates. Since the examined trends are forward-
looking in the sense that the trend ﬁltering algorithms use future data, agency ratings exhibit
important characteristics one would expect from ratings that see through the cycle.
Keywords Default risk Á Credit ratings Á Through-the-cycle Á Hodrick-Prescott ﬁlter Á
JEL Classiﬁcation G20 Á G33
A key characteristic of corporate credit ratings produced by the major rating agencies is
that they are meant to look through the cycle.
The agencies’ aim is to base rating
Institute of Finance, University of Ulm, Helmholtzstrasse 18, 89069 Ulm, Germany
Note that this paper deals with corporate credit ratings. Structured ﬁnance ratings, which feature prom-
inently in the discussion of the subprime crisis, are assigned by different rating units based on a different
rating approach. An assessment of rating quality should therefore be conducted separately for the two types
of ratings. The methodology for sovereign ratings is more similar. Due to signiﬁcant differences in the
determinants of corporate and sovereign defaults, however, the conclusions of the paper should not be
translated to sovereign ratings.
Rev Quant Finan Acc (2013) 40:623–646