Can inventory traders profit from company bond market information? Sure. Actually, fairness portfolios constructed utilizing bond momentum indicators could outperform their conventional fairness value momentum counterparts.
However as our examine demonstrates, the sign design is vital.
Momentum Spillover
The momentum spillover impact describes the sign that an organization’s bond momentum sends about its future inventory returns and is attributed to info asymmetry within the monetary markets.
There are a number of the explanation why bond market information might need distinctive insights for fairness traders:
Institutional traders with superior experience and entry to extra and higher information dominate the bond markets relative to their fairness counterparts. This may occasionally give the bond markets an informational benefit.
Since bonds have extra predictable future money flows, their costs could higher mirror their basic worth.
Low liquidity and excessive transaction prices could insulate bond markets from hypothesis and short-term volatility.
Bond Momentum Design
Harvesting the momentum spillover premium requires an appropriately designed bond momentum sign. In contrast to inventory momentum, bond momentum has no single definition. In response to the educational literature, bond momentum indicators take three kinds:
Complete Return Bond Momentum displays the aggregated trailing whole return of all of an organization’s excellent bonds.
Extra Return Bond Momentum describes the distinction between the bond whole return and period matched risk-free bond whole return.
Unfold Change Bond Momentum is the destructive worth of the unfold change.
In “Momentum in Company Bond Returns,” Gergana Jostova et al., study Complete Return Bond Momentum and determine a robust momentum impact in non-investment-grade bonds. However rating shares based mostly on bond whole return, or rate of interest and unfold return, could also be ill-advised for the reason that former is a scientific issue pushed by sovereign rate of interest dynamics. Consequently, the rate of interest publicity of an organization’s debt can considerably affect Complete Return Bond Momentum. That’s the reason we focus right here on Unfold Change Bond Momentum and Extra Return Bond Momentum.
Making use of Bond Momentum to an Fairness Portfolio
Our bond dataset is predicated on the Russell 1000 inventory universe and begins in 2003, shortly after the launch of the Commerce Reporting and Compliance Engine (TRACE) fixed-income database. We mapped company bond securities to their shares utilizing a typical firm ID. As of December 2022, about 60% of Russell 1000 corporations representing 86% of the index’s whole market cap have bond information protection.
We computed market-value-weighted extra bond returns and unfold modifications for all debt-issuing firms with a trailing three-month lookback window and constructed factor-mimicking portfolios by sorting shares into quintiles (Q1 to Q5) based mostly on their bond momentum scores. The primary chart presents the efficiency abstract of equally weighted and market-cap weighted Q1 to Q5 issue portfolios, together with a Carhart momentum issue portfolio for comparability functions .
Each bond momentum indicators outperformed conventional fairness momentum on an equal- and market-cap-weighted foundation and had greater info ratios. Moreover, Unfold Change Bond Momentum eclipsed Extra Return Bond Momentum with greater Q1 annualized returns and Q1 to Q5 return spreads.
Hypothetical Bond Momentum Portfolio Efficiency Abstract(Russell 1000, 2003 to 2022)
Evaluation
That Unfold Change Bond Momentum outperforms Extra Bond Momentum is not any coincidence. There are some basic explanations for this consequence. Utilizing primary bond math, we decompose bond extra return into unfold carry return and unfold value return in Equations 1 to six beneath. Unfold carry return is a perform of unfold stage whereas unfold value return is pushed by unfold change. Unfold change is the one part that immediately captures company-specific market sentiment.
We additionally utilized Fama–Macbeth regressions to additional consider the 2 bond momentum indicators. Particularly, we ran cross-sectional regressions every month utilizing one-month ahead inventory returns as unbiased variables and customary inventory components plus bond momentum as dependent variables. The mannequin outputs are introduced within the following desk.
Inventory Return and Bond Momentum Elements: Cross-Sectional Evaluation, 2003 to 2022
Mannequin 1 is a baseline Fama–French three-factor mannequin plus return on fairness (ROE), Low Volatility, and Momentum. Mannequin 2 expands on Mannequin 1 by including Extra Return Bond Momentum as an unbiased variable. Mannequin 3 makes use of Unfold Change Bond Momentum as the extra variable, whereas Mannequin 4 contains each bond momentum indicators as explanatory variables.
The outputs from Mannequin 2 and Mannequin 3 point out that each bond momentum indicators can enhance the explanatory energy of the baseline mannequin, or Mannequin 1. When included as a stand-alone variable, Unfold Change Bond Momentum reveals greater statistical significance than Extra Return Bond Return, and when each indicators are included, Unfold Change Bond Momentum higher predicts future inventory returns.
Conclusion
The extra extensively out there bond information turns into, the extra lecturers and practitioners will apply it to fairness sign analysis. Primarily based on our evaluation of the company bonds of US large-cap shares, a well-designed bond momentum sign that successfully captures market sentiment can assist obtain vital fairness alphas, and as our backtest and cross-sectional evaluation present, Unfold Change Bond Momentum is the best method to harvest this momentum-spillover premium.
Additional Studying
Bittlingmayer, G., and Shane Moser. “What Does the Company Bond Market Know?” The Monetary Overview.
Chan, Louis Okay. C., Narasimhan Jegadeesh, and Josef Lakonishok. “Momentum Methods.” Journal of Finance.
Dor, Arik Ben, and Zhe Xu. “Ought to Fairness Buyers Care about Company Bond Costs? Utilizing Bond Costs to Assemble Fairness Momentum Methods.” The Journal of Portfolio Administration.
Gebhardt, William R., Soeren Hvidkjaer, and Bhaskaran Swaminathan. “Inventory and Bond Market Interplay: Does Momentum Spill Over?” Journal of Monetary Economics.
Israel, Ronen, Diogo Palhares, and Scott A. Richardson. “Widespread Elements in Company Bond Returns.” Journal of Funding Administration.
Gergana Jostova, Stanislava Nikolova, Alexander Philipov, and Christof W. Stahel. “Momentum in Company Bond Returns.” Overview of Monetary Research.
Lee, Jongsub, Andy Naranjo, and Stace Sirmans. “CDS Momentum: Sluggish-Shifting Credit score Scores and Cross-Market Spillovers.” The Overview of Asset Pricing Research.
Wiltermuth, Pleasure J. “Digital Buying and selling in U.S. Company Bonds Is Lastly Taking Off. However It’s Nonetheless Early Days, Says This Investor.” MarketWatch.
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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.
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