Momentum and Reversal Effects in Corporate Bond Prices and Credit Cycles

Abstract

This article studies momentum and reversal patterns in corporate bond prices. The authors analyze returns on two momentum trading strategies—buying bonds with the best past performances (past winners) and buying bonds with the worst past performances (past losers). They consider formation and holding periods of 1 to 24 months. In the case of high-yield bonds, a strategy that buys past winners provides higher cumulative returns than a strategy of buying past losers over the 1998–2009 period. The authors show that this momentum pattern can be attributed to the behavior of credit spreads during a credit cycle. Specifically, the momentum effect is strongest during periods of widening credit spreads and dominates the reversal effect that can be observed during periods of decreasing credit spreads. Alternately, the prices of investment-grade bonds exhibit a reversal pattern, which is due to differences in the durations of the bonds. In this study, the authors also adjust the returns of these portfolios for realistic transaction costs, estimate their risk, and address possible issues of liquidity.