Corporate Bond Returns as a Function of Credit Rating Outlooks

In a period selected for comparative stability of risk premiums, non-distressed high yield corporate bonds with Negative Outlooks from Moody’s Investors Service and Standard & Poor’s outperformed those with Positive Outlooks. This counterintuitive result did not arise from confounding factors such as differences in the two categories’ mixes of ratings or maturities. An examination of financial and operational developments at the issuers of the highest-return bond in each category points to an explanation involving investors’ limited ability to predict the future course of issuers’ credit quality. The data obtained in this study suggest that active fixed income investors and portfolio managers could employ the resources devoted to security selection most productively by focusing on seemingly vulnerable credits rather than those already seen as improving by the market and the rating agencies. This study also suggests a useful framework for performance attribution analysis.