A spreadsheet with some publicly available accounting and market based information can do a better job at predicting the probability that companies will default than the ratings agency Standard and Poor’s, according to a paper released by economists Jens Hilscher and Mungo Wilson, of Brandeis and Oxford Universities.
At the core of the paper are corporate bond ratings by Standard & Poor’s. Hilscher and Wilson look at all assessments that have been given between 1986 and 2008.
Additionally, they constructed an alternative indicator that is meant to gauge the default risk of the bond issuers. The economists only use publicly available information for this “failure score”, mainly balance sheet data like profitability, leverage and cash holdings.
The authors conclude (pdf):
We find that this measure… is substantially more accurate than rating at predicting failure at horizons of 1 to 10 years.
The higher accuracy in predicting the cumulative failure probability is driven by a much higher ability of failure score at predicting marginal default probabilities at horizons of up to 2 years and the fact that credit rating adds little information to marginal default prediction at horizons up to 5 years.
In other words:
Ratings are in fact a poor predictor of corporate failure.
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