What Market Prices Reveal about Credit Quality
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.
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Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
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