SSRN-Issuer Quality and Corporate Bond Returns by Robin Greenwood, Samuel Hanson

Fascinating. The simple version is that bond returns are low in periods when a higher percentage of low rated firms issue. Once again it suggests that markets are not as efficient as we used to think.

SSRN-Issuer Quality and Corporate Bond Returns by Robin Greenwood, Samuel Hanson:

"..time-series variation in the average quality of debt issuers may be useful for forecasting excess corporate bond returns. We show that when issuance comes disproportionately from lower quality borrowers, future excess returns on high yield and investment grade bonds are low and often significantly negative. The degree of predictability is large in both economic and statistical terms, with univariate R2 statistics as high as 30% at a 3-year horizon."

What causes this? In truth it could be a couple of things. Suppose a world where all firms line up to issue debt and the good ones go first. Of course this has the problem of why the good firms "stop issuing later". A second explanation, and the one Greenwood and Hanson focus on is that the market prices credit differently and when the price of credit quality drops, the lower quality firms come to market.

The paper is best summarized by the authors themselves:

"Our main innovation is to use measures of the quality of corporate debt issuers to forecast excess returns on corporate bonds. Why might issuer quality be a useful barometer of credit market activity? Suppose that debt issuance responds to changes in the expected returns to credit, i.e., firm managers issue more debt when credit is “cheap”....Thus, time-series variation in the quality of debt issuers may be useful for forecasting corporate bond returns. Specifically, following periods when debt issuers are of particularly low credit quality, we might expect credit assets to underperform."

And that is exactly what they find. Namely: following periods of more lower quality issuances, bond underperform.

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