Thinking about cross-asset sector rotation decisions requires analysis of the lead-lad relations between asset classes. One key relationship is between credit and equity. The question is whether past stock returns can tell us something about future credit spread behavior, returns after accounting for the underlying Treasury returns.
The Merton model for pricing corporate debt tells us that the value of the firm can be viewed as a combination of options representing debt (put options) and equity, the residual value of the firm, (call option). If there is a shock to the equity of the firm, there should also be an impact on the credit-worthiness of debt. The same could be said if there is a shock to debt albeit to a lesser extent since spreads represent a credit and default premium.
The lead-lag return relationships have been explored by a number of researchers, see more recently "The lead-lag relationship between the stock and the bond markets" by Konstantinos Tolikas. While there is not complete agreement, the evidence does point to the fact that equity returns lead debt moves as measured by cross correlations and Granger causality tests. Now, both stocks and bonds can react to a common factor, but the speed of adjustment seems to be faster in equity markets.
The strength of this relationship will vary across the credit spectrum. Equity returns lead high yield bonds but not as strongly for investment grade bonds. High yield debt which has a higher default premium will be more sensitive to any change in underlying equity returns. The author looks at bond indices for his testing, but points out that while there may seem to be exploitable profit opportunities, they may not positive after accounting for all transaction costs.
We have looked at the relationship using credit fixed income ETFs minus Treasury returns and found there is a positive return relationship for both investment and high yield indices; however, the impact is more meaningful intra-month. Longer-term there is positive relationship with past equity returns albeit not at the levels of significance normally used for testing (.05 p-value).
Nevertheless, global macro should watch the relationship between stocks and bonds to exploit credit spread opportunities. Large stock sell-offs will signal poorer credit health for firms. From an alternative risk premia perspective, credit premia will be aligned with equity premia. Holding both credit and equity premia may be closely integrated, so care should be taken when trading in both ARPs to find their uniqueness.
We have looked at the relationship using credit fixed income ETFs minus Treasury returns and found there is a positive return relationship for both investment and high yield indices; however, the impact is more meaningful intra-month. Longer-term there is positive relationship with past equity returns albeit not at the levels of significance normally used for testing (.05 p-value).
Nevertheless, global macro should watch the relationship between stocks and bonds to exploit credit spread opportunities. Large stock sell-offs will signal poorer credit health for firms. From an alternative risk premia perspective, credit premia will be aligned with equity premia. Holding both credit and equity premia may be closely integrated, so care should be taken when trading in both ARPs to find their uniqueness.
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