Bond Return, Spread Change, and the Momentum Effect in Corporate Bond and Stock Markets

Abstract

This paper examines the momentum effect and its causes, the persistence in default risk change in particular, in both corporate bond and stock markets. Using a comprehensive bond dataset, we observe a significant momentum effect in corporate bond returns and bond credit spread changes. The momentum effect in bond total returns, however, is confined to low-grade bonds and can be attributed to compensation for bearing a varying default risk and term risk. This paper shows that the change in bond credit spread, not the total return, is a more appropriate proxy to examine the response of bond prices to new information of firm fundamentals. Past spread changes have robust predictive power for future spread changes even after controlling for risk characteristics such as duration and yield-to-maturity. This paper also documents the integration of the momentum effect across bond and stock markets. Equity returns, bond returns and bond spread changes are contemporaneously correlated. Equity winners (losers) are also bond winners (losers) with improved (deteriorated) credit quality and vice versa. Equity return momentum exhibits spillover to both bond returns and spread changes, although the spillover to bond returns can only be observed after controlling for default risk. Firms earning extremely low equity returns over the past six months increase bond spreads significantly in the next six months. After controlling for the yield-to-maturity, extreme equity winners (losers) earn high (low) bond returns. Although past bond returns have no predictive power for future stock returns, there is a significant momentum spillover from spread changes to stock returns. Past spread changes can explain half of momentum profit in future stock returns. This result indicates that the persistence in the default risk change may play an important role in understanding the source of momentum profits in equity returns.