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Variability of Default Rates by Rating Category

Variability of Default Rates by Rating Category Moody’s ratings measure relative risk over a continuous horizon and do not target specific expected default probabilities over specific horizons. Realized default frequencies are, in fact, quite variable over short periods of time. For example, as indicated in Exhibit 6, the standard deviation of five-year cumulative default rates is almost as large — and in Aaa through A categories, larger — than the mean five-year default rate for those same rating categories.

Exhibit 6 also shows that there is greater dispersion of default outcomes at lower rating categories. This greater dispersion is the result of two contributing factors. Economic events have a greater impact on lower- rated firms due to their greater vulnerability to shocks. Also, Moody’s typically adjusts ratings modestly — not sharply — through the credit cycle because the amplitude and timing of cycles are inherently hard to predict.

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The reason why there is dispersion in actual default rates for annual cohorts is that Moody’s does not endeavor to maintain constant ex-post default rates in various credit cycles. Given that Moody’s ratings tar- get multiple horizons, even with perfect information about the credit cycle, it would be difficult to prescribe the “correct” amount by which ratings should adjust in response to cyclical variations while maintaining constant ex-post default rates for each horizon.

Some investors, however, are very concerned with the expected absolute default rate associated with rat- ings over short horizons—particularly in the high-yield sector. To meet these investors’ needs, Moody’s pro- vides a model-based, monthly forecast of the one-year-ahead, speculative-grade default rate. This model, and models like it, can be used by investors to translate Moody’s “through-the-cycle” relative rating system to a “point-in-time” cardinal rating system.

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