CDS Momentum: Slow-Moving Credit Ratings and Cross-Market Spillovers

Abstract

We show that endogenous information signaling in the CDS market, together with sluggish updates on corporate credit ratings assigned by major rating agencies, creates anomalies such as return momentum within the CDS market and across CDS-to-stock return momentum. Using 5-year credit default swap (CDS) contracts on 1,247 U.S. firms from 2003 to 2011, a three-month formation and one-month holding period CDS momentum strategy yields 52 bps per month with a Sharpe ratio of 0.423. The performance is better for entities with lower credit ratings (83 bps per month), high CDS depth (80 bps per month), and during the financial crisis (97 bps per month). Furthermore, our cross-market tests show that by incorporating past CDS returns into the stock momentum portfolio formation process, traditional stock momentum strategies avoid abrupt losses during the crisis period and improve their performance by a net of 104 bps per month. This joint-market momentum strategy is particularly profitable for entities with high CDS depth. Importantly, we show that both within the CDS market and CDS-to-stock joint-market, momentum profits exist because CDS returns correctly anticipate future credit rating changes. This mechanism completely differentiates CDS momentum from bond return momentum.