Market predicts future ratings, says Fitch

Fitch has released a study that says there is a strong correlation between movements in credit default swap implied ratings and when changes occur to a company’s actual ratings over a one- to three-year time period. Analysis of agency rating actions observed between January 2001 and July 2008 indicated two clear relationships. Firstly, the probability of a rating downgrade increases as the negative notch differential of CDS IRs increases. Secondly, the rate of upgrades exponentially increases as CDS IR notch differentials become more positive.

The significance of this finding, Fitch notes, is the ability for the IR model to forecast future agency rating actions, thus fashioning the CDS IR model as an investment screening, portfolio monitoring, and risk management tool. As a result, portfolio managers will be better-equipped to make informed decisions regarding exposure and meet their investment objectives.