Volatility is more timely indicator of credit risk than ratings

As different spread classes reflect different degrees of credit risk, it makes sense to break down the portfolio into spread class baskets. Alternatively, one could break down the portfolio into rating buckets. However, we believe that market indicators like spread levels and spread volatility are more timely indicators of credit risk than ratings. Abond with a high spread will have a lower implied rating than a bond with a low spread no matter what the official ratings awarded by rating agencies are. For many issuers implied rating and agency rating will be the same. But, as Breger et al. (2003) have shown for the US market, as much as half of the implied ratings can differ from agency ratings. They also find that implied ratings yield superior spread risk forecasts. The analysis of implied volatilities is also an important source of information for the corporate bond manager.

Campbell and Taksler (2002) show that implied equity volatilities are at least as successful as bond ratings when it comes to explaining the development of bond spreads. Therefore, implied volatility should be watched very closely. Not only is this a possible indicator for the credit analyst, it is also important for the risk allocator within his integrated risk management in a dynamically protected portfolio, especially in the portfolio construction phase. This example shows how important a close cooperation between the corporate analysts covering the single bonds, issuers and sectors and the risk manager allocating the risk components is.

Volatility is more timely indicator of credit risk than ratings

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