Credit Spreads, Rating Downgrades, and Downside Performance: A Market-Informed Approach to Monitoring Credit Risk

21 Pages Posted: 26 Mar 2020 Last revised: 27 Mar 2020

See all articles by Wei Dai

Wei Dai

Dimensional Fund Advisors

Alan Hutchison

Dimensional Fund Advisors

Samuel Yusun Wang

Dimensional Fund Advisors

Date Written: March 26, 2020

Abstract

This paper studies the differential credit risks embedded in the cross-section of credit spreads. Using corporate bond data from 1999 to 2018, we find that credit spreads relative to those of peers — defined as bonds with the same stated credit rating — contain reliable information about future bond performance and credit migration. Bonds with substantially higher credit spreads relative to those of their peers have higher rates of future downgrades. Using the midpoint between the peer spread curve and the next-lower-rated spread curve as a threshold, we observe that the downgrade frequency in the next three to 12 months is three to four times higher, on average, for bonds above the midpoint compared to those below. We also find that bonds with considerably wider credit spreads behave more in line with bonds with lower credit ratings in terms of average return, volatility, and downside performance. Our results suggest that complementing stated credit ratings with real-time market price data can improve credit risk monitoring.

Keywords: Corporate Bonds, Fixed Income, Credit Spreads

JEL Classification: G11, G12, G14

Suggested Citation

Dai, Wei and Hutchison, Alan and Wang, Samuel Yusun, Credit Spreads, Rating Downgrades, and Downside Performance: A Market-Informed Approach to Monitoring Credit Risk (March 26, 2020). Available at SSRN: https://ssrn.com/abstract=3561260 or http://dx.doi.org/10.2139/ssrn.3561260

Wei Dai

Dimensional Fund Advisors ( email )

6300 Bee Cave Road, Building One
Austin, TX 78746
United States

Alan Hutchison

Dimensional Fund Advisors ( email )

6300 Bee Cave Road, Building One
Austin, TX 78746
United States

Samuel Yusun Wang (Contact Author)

Dimensional Fund Advisors ( email )

6300 Bee Cave Road, Building One
Austin, TX 78746
United States

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