A Better Criterion for Forced Selling in Bond Markets: Credit Ratings versus Credit Spreads

During the global financial crisis, a bond portfolio manager using only credit ratings suffered from significant losses due to their lagging properties, and now focuses on market-based criteria as another credit risk measure for forced selling. In this study, we verify whether a market-based criterion outperforms in running the forced selling strategy for bond portfolios. In contrast to the market expectation, our empirical results show that the forced selling strategy with only market measures is inferior to the rating-based strategy in terms of risk-adjusted returns, although market measures precede changes in bond ratings. This result stems from the high volatility of market-based credit measures, which results in too frequent or too early sale of a bond with credit deterioration. The improvement of risk-return trade-off observed only when market measures are jointly considered with bond ratings. This implies that market-based credit measures have complementary benefits for detecting credit risk changes. In addition, these results are robust, even for credit-stressed bond portfolios, and for credit-stressed market conditions.