You would think that debt rating would be unrelated to stock return: Low risk companies would be balanced out by low return, while high risk companies would be balanced out by high return.
Historically however this is not the case. Eric Falkenstein, a former analyst at Moody’s, presented an analysis of total return to stocks by debt rating since 1975.
For most debt ratings common wisdom holds true, with similar returns across debt ratings. BBB and BB companies have slightly outperformed the rest, including AAA.
But here’s the catch. B and C rated companies have significantly worse stock returns. Falkenstein comments:
The result is really corroborated by Campbell, Hilscher and Szilagyi (2005), who found distress risk to be negatively correlated with stock returns, which makes sense because volatility and leverage is inversely correlated with future returns, and cash-flow is positively correlated with future returns, so those are the main drivers of default risk.
In short, risky bets probably aren’t worth it.
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