Economic links from bonds and cross-stock return predictability

Abstract

Identifying firms’ bond-market-specific economic links through credit-rating comovement of their corporate bonds, a long-short strategy for stocks based on these links generates a risk-adjusted alpha of 0.45% per month, which cannot be explained by existing economic links in the literature. Market segmentation between the equity and bond markets appears to be the underlying mechanism: ($i$) The cross-return predictability is muted in the bond market; ($ii$) The cross-return predictability is mitigated in the presence of cross-holding investors; ($iii$) Equity analysts slowly incorporate information from rating-comovement links to their forecasts.