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A better criterion for forced selling in bond markets: Credit ratings versus credit spreads

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  • Choi, Jae Yong
  • Yi, Junesuh
  • Yoon, Sun-Joong

Abstract

During the global financial crisis, a bond portfolio manager using only credit ratings suffered from significant losses due to their lagging properties, and now focuses on market-based criteria as another credit risk measure for forced selling. In this study, we verify whether a market-based criterion outperforms in running the forced selling strategy for bond portfolios. In contrast to the market expectation, our empirical results show that the forced selling strategy with only market measures is inferior to the rating-based strategy in terms of risk-adjusted returns, although market measures precede changes in bond ratings. This result stems from the high volatility of market-based credit measures, which results in too frequent or too early sale of a bond with credit deterioration. The improvement of risk-return trade-off observed only when market measures are jointly considered with bond ratings. This implies that market-based credit measures have complementary benefits for detecting credit risk changes. In addition, these results are robust, even for credit-stressed bond portfolios, and for credit-stressed market conditions.

Suggested Citation

  • Choi, Jae Yong & Yi, Junesuh & Yoon, Sun-Joong, 2020. "A better criterion for forced selling in bond markets: Credit ratings versus credit spreads," Finance Research Letters, Elsevier, vol. 37(C).
    • Handle: RePEc:eee:finlet:v:37:y:2020:i:c:s1544612319304611
    DOI: 10.1016/j.frl.2020.101437
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    References listed on IDEAS

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    4. Ramin P. Baghai & Henri Servaes & Ane Tamayo, 2014. "Have Rating Agencies Become More Conservative? Implications for Capital Structure and Debt Pricing," Journal of Finance, American Finance Association, vol. 69(5), pages 1961-2005, October.
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    Cited by:

    1. Puneet Pasricha & Dharmaraja Selvamuthu & Guglielmo D’Amico & Raimondo Manca, 2020. "Portfolio optimization of credit risky bonds: a semi-Markov process approach," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 6(1), pages 1-14, December.

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    More about this item

    Keywords

    Forced selling; Credit rating; Credit spreads; Bond portfolio management; Credit risk management;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

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