Value Investing in Credit Markets

September 03, 2012
  • Contributors:

    Maria Correia, Scott A. Richardson, A. Irem Tuna
  • Topic:

    Other Research

Review of Accounting Studies

In this paper we outline an approach to make use of accounting and market based information to forecast corporate default. We evaluate a wide set of default forecasting models that make varying use of accounting and market based information.

We find that modified structural model approaches of the type used by Moody’s/KMV are best able to forecast bankruptcies out-of-sample for a set of 1,797 bankruptcies over the 1980 to 2010 period. We then find that these superior default forecasts are also able to explain relatively more of the cross-sectional variation in credit spreads for a sample of around 2,000 corporate bonds over the 1997 to 2010 period, and 453 credit-default-swap contracts over the 2005 to 2010 period.

The most interesting result that we document is the predictive information content of these default forecasts relative to the physical default forecast implicit in actual credit spreads. We find a robust positive association between the differences in actual credit spreads and implied credit spreads based on our best default forecast models and future credit returns.

This relation is robust to (i) industry controls, (ii) inclusion of known equity risk factors, and (iii) alternative weighting schemes. This positive relation is suggestive of a role for structured use of accounting and equity market information to serve as an anchor for evaluating actual credit market data.

  • AQR Capital Management, LLC, (“AQR”) provide links to third-party websites only as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by us of any content or information contained within or accessible from the linked sites. If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which has no control. In no event will AQR be responsible for any information or content within the linked sites or your use of the linked sites.

  • The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees.

    This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

  • Certain publications may have been written prior to the author being an employee of AQR.