risks in relying on ratings from credit rating agencies
Relying on ratings from credit rating agencies has some risks. Four specific risks are:
- Credit ratings are dynamic: Credit ratings change over time. Rating agencies may update their default risk assessments during the life of a bond. Higher credit ratings tend to be more stable than lower credit ratings.
- Rating agencies are not perfect: Ratings mistakes occur from time to time. During a past period, subprime mortgage securities were assigned much higher ratings than they deserved.
- Event risk is difficult to assess: Risks that are specific to a company or industry are difficult to predict and incorporate into credit ratings. Litigation risk to tobacco companies is one example. Events that are difficult to anticipate, such as natural disasters, acquisitions, and equity buybacks using debt, are not easily captured in credit ratings.
- Credit ratings lag market pricing: Market prices and credit spreads can change much faster than credit ratings. Additionally, two bonds with the same rating can trade at different yields. Market prices reflect expected losses, while credit ratings only assess default risk.