Economic Links from Bonds and Cross-Stock Return Predictability

Abstract

Identifying firms linked economically through the comovement of the credit rating of their corporate bonds, we find that a long-short strategy for stocks based on the link generates a risk-adjusted alpha of 0.62 percent per month, which cannot be explained by industry, customer-supplier, single- to multi-segment, foreign, technology, geographic, or shared analyst coverage links documented in the literature. The cross-return predictability is not significant in the bond market, and is mitigated in the presence of cross-holding investors. Furthermore, analysts are slow to update their forecasts in response to news regarding bond-linked peer firms. Overall, our results are consistent with limited investor attention due to market segmentation between the equity and bond markets.

Keywords: Economic linkage, cross-firm return predictability, credit-rating comovement, market segmentation, market inefficiency

JEL Classification: G12, G14, G23, G24