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Market-Based Evaluation for Models to Predict Bond Ratings

Author

Listed:
  • Konan Chan

    (Department of Finance, College of Management, National Taiwan University, Taipei 10660, Taiwan, ROC)

  • Narasimhan Jegadeesh

    (Goizueta Business School, Emory University, 1300 Clifton Road, Atlanta, GA 30322-2722, USA)

Abstract

Previous studies have examined different statistical models to predict corporate bond ratings. However, these papers use agency ratings as the benchmark to assess models and ignore the evidence that agency ratings may not be accurate in a timely manner. In this paper, we propose a new approach which incorporates ex-post bond returns to evaluate rating prediction models. Relative rating strength portfolios, formed by buying under-rated bonds with agency ratings lower than model ratings and selling over-rated bonds with agency ratings higher than model ratings, are employed to test the performance of different statistical models in rating predictions. Our results show that one version of multiple discriminant analysis model can generate a statistically significant abnormal return of 5% over a 5-year horizon. The ordered probit model which is believed to possess theoretical advantages in classifying bonds does not perform better. This suggests that using traditional measures to evaluate models can be misleading. The existence of a profitable trading strategy also raises the concern of market efficiency in the corporate bond market.

Suggested Citation

  • Konan Chan & Narasimhan Jegadeesh, 2004. "Market-Based Evaluation for Models to Predict Bond Ratings," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 7(02), pages 153-172.
    • Handle: RePEc:wsi:rpbfmp:v:07:y:2004:i:02:n:s0219091504000081
    DOI: 10.1142/S0219091504000081
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    Citations

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    Cited by:

    1. Arundina, Tika & Azmi Omar, Mohd. & Kartiwi, Mira, 2015. "The predictive accuracy of Sukuk ratings; Multinomial Logistic and Neural Network inferences," Pacific-Basin Finance Journal, Elsevier, vol. 34(C), pages 273-292.
    2. Brian BARNARD, 2017. "Rating Migration and Bond Valuation: Decomposing Rating Migration Matrices from Market Data via Default Probability Term Structures," Expert Journal of Finance, Sprint Investify, vol. 5, pages 49-72.
    3. Yasean A. Tahat & Ahmed H. Ahmed & Mohammad M. Alhadab, 2018. "The impact of intangibles on firms’ financial and market performance: UK evidence," Review of Quantitative Finance and Accounting, Springer, vol. 50(4), pages 1147-1168, May.
    4. Ken Hung & Hui Wen Cheng & Shih-shen Chen & Ying-Chen Huang, 2013. "Factors that Affect Credit Rating: An Application of Ordered Probit Models," Journal for Economic Forecasting, Institute for Economic Forecasting, vol. 0(4), pages 94-108, December.
    5. Jaspreet Kaur & Madhu Vij & Ajay Kumar Chauhan, 2023. "Signals influencing corporate credit ratings—a systematic literature review," DECISION: Official Journal of the Indian Institute of Management Calcutta, Springer;Indian Institute of Management Calcutta, vol. 50(1), pages 91-114, March.
    6. Alan V. S. Douglas & Alan G. Huang & Kenneth R. Vetzal, 2016. "Cash flow volatility and corporate bond yield spreads," Review of Quantitative Finance and Accounting, Springer, vol. 46(2), pages 417-458, February.
    7. Brian BARNARD, 2018. "Rating Migration and Bond Valuation: Ahistorical Interest Rate and Default Probability Term Structures," Expert Journal of Finance, Sprint Investify, vol. 6(1), pages 16-30.
    8. Brian BARNARD, 2017. "Rating Migration and Bond Valuation: Decomposing Rating Migration Matrices from Market Data via Default Probability Term Structures," Expert Journal of Finance, Sprint Investify, vol. 5(1), pages 49-72.
    9. Poon, Winnie P.H. & Chan, Kam C., 2008. "An empirical examination of the informational content of credit ratings in China," Journal of Business Research, Elsevier, vol. 61(7), pages 790-797, July.
    10. Hong-Yi Chen & Hsiao-Yin Chen, 2016. "Inconsistent Bond Pricing in a Rational Market," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 19(03), pages 1-17, September.
    11. Ghadeer Khartabiel & Ahmad Abu-Alkheil & Tunku Salha Tunku Ahmad & Walayet Khan, 2020. "Shari’ah-compliant Sukuk versus conventional bond announcements: is there a wealth effect?," Review of Quantitative Finance and Accounting, Springer, vol. 54(3), pages 1059-1073, April.

    More about this item

    Keywords

    Bond rating prediction; relative rating strength portfolio; bond trading strategy; bond market efficiency;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services
    • G3 - Financial Economics - - Corporate Finance and Governance

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