Bonds with the same S&P or Moody’s credit rating can vary greatly in terms of their risk and subsequent return. New research shows that fixed income investors must also consider their credit spreads.
Wei Dai, Alan Hutchison and Samuel Wang contribute to the literature on fixed-income investing with their March 2020 study, “Credit Spreads, Rating Downgrades, and Downside Performance: A Market-Informed Approach to Monitoring Credit Risk.” They examined the credit risks in bonds with the same credit rating. Their data series covered fixed-rate U.S. corporate bond data from 1999 through 2018. They excluded bonds with options because their yields contain information about optionality as well as credit risk. Their resulting sample contained 1,270 unique issuers and 11,298 unique issues, and an average of 546 issuers and 2,665 issues per month. They classified bonds based on whether their credit spreads were above or below the midpoint between the spread curve for their stated credit rating and the spread curve for the next-lower credit rating. Following is a summary of their findings:
Their findings led Dai, Hutchison and Wang to conclude: “Our results suggest that complementing stated credit ratings with real-time market price data can improve credit risk monitoring.” They added: “Our empirical results are not indicative of mispricing. Instead, they highlight the important role markets play in aggregating and disseminating information in real time.”
When investing in fixed-income markets, look beyond the credit rating. A credit-monitoring process that includes information from stated credit ratings and market prices provides a more complete representation of an issuer’s credit quality. Investors focusing only on the yields of bonds or on their rating will be underestimating risk.
Larry Swedroe is the chief research officer for Buckingham Wealth Partners.
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