The investment universe consists of all NYSE, AMEX, and NASDAQ-listed U.S. stocks. Stocks with prices below 1$ are excluded.Bond characteristics come from the Mergent Fixed Income Securities Database. Exclude bonds issued under Rule 144A, bonds that are not traded in USD, and bonds with special conditions (asset-backed securities, callables, convertibles, bonds with warrants, or with zero coupons).
ASSET CLASS: stocks | REGION: United States | FREQUENCY:
Monthly | MARKET: equities | KEYWORD: Cross-Stock, Return, Predictability
I. STRATEGY IN A NUTSHELL
This strategy links U.S. stocks to peer firms whose corporate bonds exhibit rating comovement. Monthly peer returns are calculated, and focal firms are sorted into quintiles; the strategy goes long top quintile and short bottom quintile.
II. ECONOMIC RATIONALE
Credit-rating comovement provides insights overlooked by equity analysts due to bond-equity market segmentation. This lag in equity response creates cross-firm return predictability, particularly when investors trade both stocks and bonds of the same firm.
III. SOURCE PAPER
Economic Links from Bonds and Cross-Stock Return Predictability [Click to Open PDF]
Jian Feng, HKU Business School, The University of Hong Kong; Xiaolin Huo, University of International Business and Economics (UIBE), School of Finance, Renmin University of China; Xin Liu, Cornell University – SC Johnson College of Business – Finance Department; Yifei Mao, The Hong Kong Polytechnic University; Hong Xiang, The Hong Kong Polytechnic University
<Abstract>
Identifying firms linked economically through the comovement of the credit rating of their corporate bonds, we find that a long-short strategy for stocks based on the link generates a risk-adjusted alpha of 0.62 percent per month, which cannot be explained by industry, customer-supplier, single- to multi-segment, foreign, technology, geographic, or shared analyst coverage links documented in the literature. The cross-return predictability is not significant in the bond market, and is mitigated in the presence of cross-holding investors. Furthermore, analysts are slow to update their forecasts in response to news regarding bond-linked peer firms. Overall, our results are consistent with limited investor attention due to market segmentation between the equity and bond markets.
IV. BACKTEST PERFORMANCE
| Annualised Return | 4.16% |
| Volatility | 7.9% |
| Beta | N/A |
| Sharpe Ratio | 0.53 |
| Sortino Ratio | N/A |
| Maximum Drawdown | N/A |
| Win Rate | N/A |
