Should investors also ‘residualize’ bond momentum? This paper1 investigates the momentum factor in credit markets. Using Euro bond data from the years 2004-2016, the authors found that a momentum premium existed for high yield, but not for investment grade, just as is documented in the existing literature in the case of US-dollar bonds.
The most interesting analysis concerns the ‘residualization’ of bond returns. Since corporate bond returns are affected by systematic drivers, such as the interest rate, credit spread and liquidity risk, the momentum winner and loser portfolios tend to contain bonds with large exposures to these drivers. For example, in a credit bear market, especially the lower-rated, longer-dated and less liquid bonds tend to be the losers.
The authors split bond returns into their systematic and bond-specific parts. The systematic part was driven by a bond’s credit rating and its liquidity (proxied by age and size), but unfortunately duration or Duration Times Spread were not included.
The authors did find momentum in bond-specific returns, but not in systematic returns. They link this to the gradual information diffusion hypothesis of Hong and Stein (1999), stating that investors underreact to firm-specific news. However, they do not discuss the lack of a bond momentum effect in the investment grade market.
In our own research, we have found that there is also a momentum effect in Investment Grade if the stock return, instead of the bond return, of the company is used to identify winners and losers.
1Barth, Scholz & Stegmeier, 2018, “Momentum in the European Corporate Bond Market: The Role of Bond-Specific Returns”, The Journal of Fixed Income, Winter 2018
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