Interpreting price signals across markets

A company's share and bond prices offer different expressions of a company's fundamental value. But while equity and credit performance may seem to be independent, each has been shown to influence the other.

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A performance overview

The 2008 credit crisis sparked concurrent equity bear markets and recessions around the world. It also gave researchers a new impetus to examine the links between credit performance and equity performance.

The principal metric for credit quality is the credit rating, which, in the United States, is generally issued by one of three independent rating services: Standard & Poor's, Fitch Ratings, and Moody's Investors Service. These ratings can have a direct impact on the values of bonds, as shown by data published periodically by Standard & Poor's.

For example, over the 10 years that ended May 7, 2014, the median market yield for corporate bonds with 20-year terms remaining was 5.14% for AAA-rated bonds, 5.34% for AA-rated bonds, 5.55% for A-rated bonds, and 6.39% for BBB-rated bonds.

Based on those medians, a $10,000, AAA-rated bond that was suddenly downgraded one notch (to AA) could have declined in value by about $242. A similar A-rated bond that was downgraded to BBB could have declined by $934.

In the opposite direction, a BBB-rated bond that was upgraded to A could have gained approximately $1,000. An A-rated bond that was upgraded to AA could have gained $248. Keep in mind that the yield differential on any given day varied significantly from the long-term median, so the potential capital cost or price boost could vary as well.

A research overview

There have been a number of studies recently that sought to establish firm links between changes in the credit assessment of a company and changes in its share value. These efforts consider credit rating changes to be signals and attempted to measure the information value of those signals. Some studies found direct effects in all directions and all market conditions. Others found meaningful links between a credit action and an equity price change only during generally down equity markets or only as a result of ratings downgrades.

For example, a research economist working for the European Central Bank noted that "… the effects of rating actions on market prices are significant and depend on the current state of the market. In particular, when market conditions are very favorable, the changes in credit ratings are not crucial for the pricing. However, in the periods of stress in the financial markets, rating actions are a significant factor influencing market pricing."1

Another study found that "firms with low credit risk realize higher returns than firms with high credit risk … but that the negative relation between credit risk and returns is statistically and economically significant only during periods of credit rating downgrades." The principal reason for this, the paper reported, was that deteriorating companies tend to be sold by institutional investors, which leads to considerable price drops.2

A third study was focused on major banks whose shares are traded in the United States. It found that upward influence of good news was a stronger influence. "Cumulative abnormal returns exhibit a positive trajectory following an upgrade announcement whilst cumulative average abnormal returns to downgrades return almost to zero over our event window."3

A case study

While a credit rating change is a tangible event than can generate a measurable impact at a specific moment in time, credit analysis also provides a forward-looking assessment of change potential in the form of a credit outlook. This assessment can color the equity market's pricing assessments, as seen in this tabulation of long-term equity performance by companies carrying a particular current credit outlook.

Average annualized returns4

Past year Past 2 years Past 3 years Past 4 years Past 5 years
Companies with a positive credit bias 24.5% 32.1% 17.8% 20.0% 25.3%
Companies with a negative credit bias 16.9% 21.4% 7.2% 9.7% 12.1%

As you have seen, there are significant indications that credit evaluations can help shape equity valuations. But like other indicators, credit ratings alone do not appear to strictly determine equity returns, so they should be weighed carefully as only one element of an investment strategy.

Next steps to consider

Open an account with Fidelity to help build your portfolio.

Select from a variety of individual bond and bond funds that may meet your investing needs.

Bonds or bond funds are fixed income investments that generally pay a set rate of interest over a fixed time period.

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