What does 'through the cycle' rating mean and why do agencies use it?

Question

AcadiFi · Accepted Answer

Through-the-cycle (TTC) ratings attempt to reflect an issuer's credit quality over a full economic cycle (5-7 years), smoothing out short-term volatility. Point-in-time (PIT) ratings reflect the current 12-month default probability given today's conditions.

Example: Oakmere Homebuilders, an A-rated national builder in 2024 during a housing boom.
- PIT view — booming demand, rising margins, low current default risk ≈ AA equivalent
- TTC view — housing is cyclical; in a downturn, leverage and losses spike ≈ A

Agencies publish the TTC rating (A) and leave the short-term cyclical noise to the outlook and watch mechanisms. This is why agency ratings move less than CDS spreads, which are fully PIT.

```mermaid
flowchart LR
  A[Economic Cycle] --> B{Rating Approach}
  B --> C[TTC: Stable A]
  B --> D[PIT: AA then BBB]
  C --> E[Less volatile]
  D --> F[More volatile]
```

Implications for FRM:

1. Stress testing — TTC ratings already embed stress, so Basel IRB PDs floor at agency PDs.
2. Rating/CDS basis — spreads can diverge widely from ratings during cycles, creating capital structure arbitrage opportunities.
3. Procyclicality — the 2008 mass downgrades showed TTC can fail in extreme events, amplifying the crisis when banks had to sell downgraded assets.
4. Regulatory rethink — Basel IV encourages 'hybrid' approaches mixing TTC base with PIT overlays.

Key exam fact: Moody's and S&P both target TTC; investor-pays firm Egan-Jones runs closer to PIT. Know why each approach exists and the trade-off between stability and accuracy.

What does 'through the cycle' rating mean and why do agencies use it?

Master Part I with our FRM Course

Related Questions

Practice Questions