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

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.