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Momentum and Credit RatingDoron Avramov, Tarun Chordia, Gergana Jostova, and Alexander Philipov∗AbstractThis pape r establishes a robust link between momentum and credit rating. Mo-mentum profitability is large and significant among low-grade firms, but it isnonexistent among high-grade firms. The momentum payoffs documented in theliterature are generated by low-grade firms that account for less than 4% of theoverall market capitalization of rated firms. The momentum payoff differentialacross credit rating groups is unexplained by firm size, firm age, analyst forecastdispersion, leve rage, return volatility, and cash flow volatility.∗Doron Avramov is at the Robert H. Smith School of Business, University of Maryland, TarunChordia is at the Goizueta Business School, Emory University, Gergana Jostova is at the Scho ol ofBusiness, George Washington University, and Alexander Philipov is at the Kogod School of Business,American University. The authors thank Yakov Amihud, Michael Cooper, Koresh Galil, NarasimhanJegadeesh, Sheridan Titman, Lubos Pas tor, seminar participants at American University, Bank ofCanada, Emory University, University of Maryland, McGill University, University of Southern Califor-nia, the 10th Annual Finance and Accounting Conference at Tel Aviv University, Yale University, theChicago Quantitative Alliance, the Washington Area Finance Association conference, and especially ananonymous referee and an ass ociate editor for helpful comments. All errors are our own.Jegadeesh and Titman (1993) have documented that the momentum-based trading strat-egy of buying past winners and selling past losers provides statistically significant andeconomically large payoffs. The empirical evidence on stock return momentum has beenparticularly intriguing because it p oints to a violation of weak-form market efficiency.In particular, Fama and French (1996) show that momentum profitability is the onlyCAPM-related anomaly unexplained by the Fama and French (1993) three-factor mo del.Moreover, Schwert (2003) demonstrates that market anomalies related to profit opportu-nities, including the size and value effects in the cross section of average returns, as wellas time-series predictability by the dividend yield, typically disappear, reverse, or attenu-ate following their discovery. In contrast, Jegadeesh and Titman (2001, 2002) documentthe profitability of momentum strategies after its initial discovery. The robustness ofmomentum profitability has generated a variety of explanations, both behavioral andrisk based.1It has also been shown that momentum profitability is related to business conditions.Specifically, Chordia and Shivakumar (2002) document that momentum payoffs are largeduring expansions and non-existent during recessions. Avramov and Chordia (2005)demonstrate that the impact of past returns on future returns cannot be captured byconditional and unconditional risk-based asset pricing models. However, they show thatthe momentum payoffs are related to the component of model mispricing that varieswith business cycle variables such as the Treasury Bill yield, the term spread, and thedefault spread. Since credit risk varies over the business cycle, it is natural to askwhether the momentum payoffs are related to the credit risk of firms. In this paper, weprovide a new and unexplored dimension in understanding the profitability of momentumstrategies. We show that momentum profits are restricted to high credit risk firms andare nonexistent for firms of high credit quality.Specifically, based on a sample of 3,578 NYSE, AMEX, and NASDAQ firms rated byS&P over the July 1985-December 2003 period,2we show that over formation periods of1three, six, nine, and twelve months, the extreme loser and winner portfolios of Jegadeeshand Titman (1993) consist of stocks with the lowest and the next lowest credit rating,respectively. The ave rage rating of the entire sample of rated firms is BBB. The extremeloser (winner) portfolio has an average rating of BB− (BB+). The extreme losers andwinners are the only non-investment grade portfolios in the sample of rated firms.Trading strategies that condition on three credit rating and ten prior six-monthreturn groups yield momentum payoffs that increase monotonically with the credit risk –they increase from an insignificant 0.27% per month for the best quality debt tercile toa significant 2.35% for the worst. Similarly, based on ten credit rating and three pastreturn portfolios, momentum payoffs increase from an insignificant 0.07% per month forthe highest credit quality decile to a significant 2.04% for the worst. Among the low ratedfirms, loser stocks are the dominant source of return continuation and the profitability ofmomentum strategies. Based on ten credit risk and three past return groups, the returndifferential between the lowest and highest credit risk loser firms averages 1.60% permonth, whereas the return differential for the winner firms is, on average, only 0.37%.We also implement momentum strategies based on the prior six-month return fordifferent samples of rated firms, as we sequentially exclude the lowest rated firms. Strik-ingly, the significant profits to momentum strategies are derived from a sample of firmsthat accounts for less than four percent of the market capitalization of all rated firmsand for about 22 percent of the total number of rated firms. When we exclude firmswith an overall S&P rating of D, C, CC, CCC−, CCC+, B−, B, B+ and BB−, themomentum strategy payoffs from the remaining firms, which account for 96.6% of theoverall market capitalization of rated firms, become statistically insignificant.Recent work has demonstrated the significance of momentum for certain subsamplesof stocks. For instance, Jiang, Lee, and Zhang (2006) and Zhang (2006) demonstratehigher momentum payoffs among firms with higher information uncertainty. Informa-tion uncertainty is proxied by firm size, firm age, return volatility, cash flow volatility,2and analyst forecast dispersion. However, our findings suggests that the credit ratingeffect on momentum is independent of and is much stronger than the effect of all theseinformation uncertainty variables. In particular, the information uncertainty variablesdo not capture the momentum profits across credit rating groups but credit rating doescapture the momentum profits across the uncertainty variables. Specifically, momen-tum payoffs occur among large-capitalization firms that are low


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Chicago Booth BUSF 35150 - Momentum and Credit Rating

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