Equity Momentum in European Credits

Abstract

The authors investigate the phenomenon that past winners in the stock market are potential future winners in the European bond market. By using a data set of EUR-denominated bonds for the investment grade (IG) and high yield (HY) market since 2000, the authors show that the stock market leads the bond market as well as rating changes. The authors design long-only strategies with strong equity momentum exposure. A trading strategy based on these findings has an alpha of up to 1.77% (6.93%) in IG (HY). Firms with positive (negative) equity momentum have an improving (deteriorating) rating in the future. This leads to the conclusion that an underreaction of the bond market to the firm-specific information about changing default risk is a likely source of the spillover effect. TOPICS: Exchanges/markets/clearinghouses, fixed income and structured finance Key Findings • We find a strong positive relationship between equity momentum and future returns for EUR-denominated corporate bonds. • Our strategy leads to alphas up to 1.77% (6.93%) in investment grade (high yield). • Equity momentum is able to screen out bonds that are being downgraded within the next year.