What Market Prices Reveal about Credit Quality
The following research is provided by Dimensional Fund Advisors. To download their original research paper, click here.
Dimensional has managed systematic fixed income strategies since 1983, continually looking for ways to innovate and design reliable investment solutions to help our clients meet their goals. Just like our equity strategies, our fixed income strategies use market prices at every step of the investment process to pursue higher expected returns and manage risks and costs. A critical aspect of robust risk control is seeking to ensure a comprehensive assessment of an issuer’s credit quality.
One prominent source of credit assessment is Nationally Recognized Statistical Rating Organizations (NRSROs), such as Standard & Poor’s and Moody’s. In addition to NRSRO's ratings, current bond prices —as reflected in bond yields or credit spreads—provide a supplemental and continuously updated source of information about bond credit quality. Every day, numerous market participants assess the credit quality of fixed income securities using all the information at their disposal. As a result, bonds’ credit spreads should reflect—in real time—participants’ aggregate expectations and the market’s assessment of differences in credit risk.
Within a group of bonds with the same rating, there can be marked variation in credit spreads. Examining US corporate bonds between 1999 and 2018, our research shows that bonds with substantially higher credit spreads relative to those of their peers—defined as bonds with the same stated credit rating—are more likely to be downgraded in the near future. The downgrade frequency in the next three to 12 months is three to four times higher, on average, for such bonds. We also find that bonds with considerably wider credit spreads behave more in line with bonds with lower credit ratings.
These results support the use of up-to-date market prices to improve credit risk monitoring. Consistent with this research, Dimensional has developed a robust and systematic credit monitoring process that takes into account information from stated credit ratings as well as current bond prices, credit default swap prices, live bid-offer spreads, and issuers’ stock prices. For instance, if a bond is trading at substantially higher yields than its same-rated peers, Dimensional may assign that bond a lower internal rating than its stated credit rating. If the internal rating is inconsistent with the goals and constraints of a strategy, that bond may not be eligible for purchase in that particular strategy.
Investors want reliable portfolios with robust risk controls. They don’t want surprises. Our market-informed credit assessment provides a more complete picture of an issuer’s credit quality in real time, helping to ensure that our portfolios behave in a way that is commensurate with the intended credit risk exposure.
Credit Quality: Credit quality informs investors of a bond or bond portfolio's creditworthiness or risk of default.
Credit Spread: The yield difference between bonds of similar maturity but different credit quality.
Credit Default Swap: A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap" or offset his or her credit risk with that of another investor.
Yield: Bond yield is the return an investor realizes on a bond.
Credit Risk: Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations.
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