Endogenous inattention and risk-specific price underreaction in corporate bonds

Abstract

Corporate bond prices are slow to respond to default risk and interest rate shocks, as proxied by firm-level stock returns and Treasury returns, respectively. Furthermore, the underreaction is risk-specific: bonds with better credit quality underreact more to default risk, while those with worse quality underreact more to interest rates. The underreactions imply substantial out-of-sample return predictability, and investors appear to be leaving too much money on the table. The results are consistent with behavioral inattention models in which investors endogenously allocate more attention to payoff-relevant (or salient) risks, and they are not explained by traditional trading friction mechanisms.