Aurora Borealis
1 October 2017 CFA Institute Journal Review

Momentum Spillover from Stocks to Corporate Bonds (Digest Summary)

  1. Sonia Gandhi, CFA
A stock–bond momentum spillover strategy exhibits strong structural and time-varying credit risk exposure that reduces the profitability of the strategy and produces large drawdowns. If companies are ranked on their firm-specific equity returns (i.e., residual momentum) instead of their total equity returns, the credit risk exposures are halved, the Sharpe ratio doubles, and the drawdowns are substantially reduced.

How Is This Research Useful to Practitioners?

Momentum spillover from stocks to bonds is the empirical phenomenon that companies that have recently outperformed in the equity market tend to subsequently outperform in the corporate bond market. The authors’ findings, which make four contributions to the literature on momentum spillover, will be useful to practitioners who invest in corporate bonds. The authors provide new insights into the risk profile of the traditional total momentum spillover strategy and document superior performance of a new residual momentum spillover strategy. They demonstrate that (1) the spillover effect is also present for high-yield bonds, not just for investment-grade bonds; (2) a momentum spillover strategy tends to select companies with low (high) credit risk in the winner (loser) portfolio, as indicated by a variety of risk measures (credit volatility, credit market beta, credit rating, credit spread, distance to default, and leverage); (3) the credit risk exposure of a momentum spillover strategy strongly depends on the equity market return during the formation period of the momentum decile portfolios; and (4) the credit risk exposure of momentum spillover, which varies over time, can be substantially reduced by ranking companies on the basis of their residual equity returns (i.e., residual momentum) instead of their total equity returns (i.e., total momentum).

How Did the Authors Conduct This Research?

The corporate bond data cover all the constituents of the Barclays U.S. Corporate Investment Grade Index and the Barclays U.S. High Yield Index over January 1994–December 2013, and the monthly equity returns are from FactSet—resulting in a dataset of 2,439 unique companies.

To assess the return characteristics of momentum spillover, the authors use the well-known overlapping portfolio framework of Jegadeesh and Titman (Journal of Finance 1993). The authors find strong evidence that equity momentum spills over to the corporate bond market as the Sharpe ratio and alphas monotonically decrease, moving from the decile of highest equity returns (i.e., the winner portfolio) to the decile of lowest returns (i.e., the loser portfolio).

The authors then analyze the risk characteristics of the momentum decile portfolios. They find that if equity returns are lower in the formation period, the decile portfolios’ sensitivity to the credit markets is higher in the holding period, as indicated by a variety of credit risk measures. The authors review the time-varying risk of momentum spillover. They conduct a graphical analysis that plots equity market returns in the formation period against the credit risk of the winner-minus-loser portfolio, showing a clear connection: The lower the equity market return in the formation period, the higher the credit risk of the winner-minus-loser portfolio.

This finding poses a problem for the profitability of momentum spillover. If the winner-minus-loser portfolio is negatively exposed to the corporate bond market and if the corporate bond market does well after the formation period, the strategy will do relatively poorly during the holding period. This issue is exacerbated when the equity market performs poorly during the formation period, because the momentum spillover strategy becomes even more negatively sensitive to the corporate bond market in the holding period.

This time variation in the credit sensitivity of momentum spillover is both statistically and economically meaningful. The authors find that using residual equity returns (i.e., the residuals from a moving-window regression of a stock’s returns on market returns) instead of total equity returns significantly reduces the structural and time-varying credit risk exposures of momentum spillover. The results demonstrate that company selection based on residual equity returns substantially lowers the structural and time-varying risk of a momentum spillover strategy. They conclude that sorting companies on the basis of their residual momentum is effective in reducing the volatility from the traditional total momentum spillover, resulting in a superior Sharpe ratio. Moreover, there is added value in selecting companies on the basis of residual momentum that cannot be realized by directly hedging the credit risk exposure of a total momentum strategy.

Abstractor's Viewpoint

The authors’ findings will be extremely useful to anyone managing bond portfolios. By also including high-yield bonds, they add interesting nuances to prior research, which has found that past equity returns can help predict future bond returns. Practitioners who pay careful attention to both past equity prices and the technique of evaluating residual momentum spillover will find valuable insights and tools. Rating agencies also need to be more cognizant of these multiple dynamics.

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