Financial reporting, Multidimensional Graphics, Bankruptcy, Predictive ability

Edward I. Altman, Commercial Bank Lending: Process, Credit Scoring, and Costs of Errors in Lending, The Journal of Financial and Quantitative Analysis, Vol. 15, No. 4, Proceedings of 15th Annual Conference of the Western Finance Association, June 19-21, 1980, San Diego, California (Nov., 1980), pp. 813-832

Bond ratings are usually first assigned by rating agencies to public debt at the time of issuance and are periodically reviewed by the rating companies. If deemed warranted, changes in ratings are assigned after the review. A change in a rating reflects the agency’s assessment that the company’s credit quality has improved (upgrade) or deteriorated (downgrade). A coincident effect, in some proximity to the date of the rating change, is a change in the price of the issue. This article reports on an in-depth investigation of the expected ratings changes (drift) over time. Our analysis compares rating changes from the two major agencies, Moody’s and S&P, over the period 1970–1996. For the first time, results from several studies which have documented and analyzed these data patterns are contrasted. Depending upon which study one uses, the results and implications can be very different. We expect that the findings will have implications for such diverse practitioners as bond investors who concentrate on any or all segments of the corporate bond market, eg., high yield bond and “crossover” investors, mark-to-market analysts, and traders in the new and growing market for credit-risk-derivatives and for the many analysts who properly view that credit quality assessment involves the entire spectrum of possible outcomes, not just default. A follow-up study will analyze, in greater depth, two critical characteristics of the rating drift phenomenon. These are unexpected, as well as expected, rating migration patterns and also the implied impact on the price of the fixed income instrument.

The author was extremely interested to find that Professor Rick Elam had conducted a study analyzing the effect of lease data on the predictability of financial ratios, for bankruptcy prediction. Prediction could be improved by adding to the asset and liability base and the probable effect on earnings when leases are capitalized. Problem firms utilize leasing to a greater extent than non-problem firms, although this relatively greater use may change as the bankruptcy date approaches. Professor Deakin found that failed firms tended to expand quite rapidly several years prior to failure and that the "expansion was financed by increased debt and preferred stock rather than common stock and retained earnings." Elam clearly has made a contribution in his assessment of lease capitalization on ratio predictability. The analysis did not go far enough in its investigation of relative lease usage, the comprehensiveness of ratio inclusion and the sophistication of the statistical technique utilized. Since lease capitalization is now accepted by academicians and practitioners alike, a full understanding of its impact is crucial.

ABSTRACT This study develops an alternative way to measure default risk and suggests an appropriate method to assess the performance of fixed‐income investors over the entire spectrum of credit‐quality classes. The approach seeks to measure the expected mortality of bonds and the consequent loss rates in a manner similar to the way actuaries assess mortality of human beings. The results show that all bond ratings outperform riskless Treasuries over a ten‐year horizon and that, despite relatively high mortality rates, B‐rated and CCC‐rated securities outperform all other rating categories for the first four years after issuance, with BB‐rated securities outperforming all others thereafter.