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

Abstract

This paper highlights the adverse consequences of sluggish credit rating updates in creating information efficiency distortions and investment anomalies. We first document significant credit default swap (CDS) return momentum yielding 7.1% per year. We further show that cross-market momentum strategies based on information in past CDS performance generates alpha of 10.2% per year in stocks and 7.6% per year in bonds. These CDS momentum and cross-market effects are stronger among more liquid, informationally-rich CDS contracts whose CDS spreads move in anticipation of important, yet slow moving, credit rating changes.

Keywords: Credit default swaps; CDS returns; Credit ratings; Momentum; Spillover; Endogenous liquidity; Credit risk; Information flows

JEL Classification: G12; G14