Sources of Momentum in Bonds

Abstract

This paper documents that momentum profits in corporate bonds prevail during weakening aggregate credit conditions, and are driven by losers. Consistent with this, we find that a conditional default factor explains the cross-section returns of corporate bond portfolios sorted by past performance. Based on the evidence, we develop a model connecting bond momentum returns to the ability of bondholders to recover value when firms default. Specifically, we propose that firms with more (less) intangible capital and growth options are more (less) costly to liquidate and, therefore, they have lower (higher) recovery value. In this case, the bond momentum can exist, because the “recovery premium” becomes more important when firm default becomes highly probable. We provide strong empirical support to these predictions. Related, the U.S. government bonds display no momentum, yet it emerges in sovereign bond returns. Time-varying aggregate default shocks and firm characteristics determining the growth and liquidation of issuers are the main sources of momentum in bonds.