Cross-section Of Corporate Bond Returns Research Articles

Dealer inventory and the cross-section of corporate bond returns

We empirically study the role of dealers’ inventory risk in US corporate bond returns. To do so, we build a bond-level measure of exposure to inventory risk and find that the risk-adjusted return of a high-minus-low portfolio is 21 basis points per week. The inventory risk premium is amplified during times of crises, if hedging supply is low, as well as for bonds with higher credit risk. Our findings provide strong support for the asset pricing implication of inventory models and show that dealers use price pressure to compensate for bearing inventory risk.

Breadth of Ownership and the Cross-Section of Corporate Bond Returns

Using breadth of corporate bond fund ownership to proxy for the combination of short-sale constraints and divergence of opinions in the corporate bond market, this paper investigates whether and to what extent Miller’s overpricing theory holds for corporate bonds. Consistent with the theory, we document a significant and positive relation between changes in breadth and the cross-section of future corporate bond returns. Because of the bounded upside of debt, the ability of changes in breadth to predict returns appears to be less pronounced for corporate bonds relative to stocks. Furthermore, this predictability is stronger among bonds with higher credit risk, indicating that the effect of short-sale constraints and divergence of opinions on bond mispricing tends to be larger for riskier bonds with more upside potential and, thus, more scope for overvaluation. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The internet appendix and data are available at https://doi.org/10.1287/mnsc.2023.4950 .

Which uncertainty measures matter for the cross-section of corporate bond returns? Evidence from the U.S. during 1973–2020

I examine which economic uncertainty measures matter for the cross-section of corporate bond returns using 40 corporate bond portfolios for a long period from 1973 to 2020. Out of a comprehensive list of 24 economic uncertainty measures, I find that tax policy uncertainty is the most significant both economically and statistically. I also find that measures that are documented as significantly priced factors – VIX, EPU, and economic uncertainty measures (Jurado et al., 2015) – are not robust to the long sample period and my empirical approach to rigorously estimate uncertainty shocks.

Jump and volatility risk in the cross-section of corporate bond returns

Investigating the pricing of jump and volatility risk in the cross-section of corporate bonds, we find that bonds with high jump and volatility betas have low expected returns. The jump and volatility risk effects are economically significant, exhibit an intra-rating pattern, and increase as ratings decrease. While both jump and volatility risk effects heighten during the subprime crisis period, jump risk becomes more important than volatility risk in times of stress. The pronounced negative jump and volatility risk premiums cannot be explained by coskewness, cokurtosis, or downside risk exposure and are robust to controlling for conventional risk factors and bond characteristics.

Inflation Volatility Risk and the Cross-section of Corporate Bond Returns

As corporate bonds are primarily denominated in nominal terms, inflation uncertainty arises as a relevant source of risk. This paper analyzes the relevance of inflation volatility risk as an additional factor predicting the cross-section of corporate bond returns. I find a negative and significant inflation volatility risk premium (IVRP) obtained from the difference between high inflation and low inflation beta portfolios. Further, common risk factors in the equity and corporate bond markets do not explain the IVRP, it responds to ex-post inflation risk and is partially explained by market risk and monetary policy shocks. Lastly, I show that the IVRP is associated with firms incurring in debt maturity management to mitigate refinancing risks.

Downside Risk and the Cross-section of Corporate Bond Returns

We rationalize in a theoretical framework the empirically documented importance of volatility and downside risk in the cross-section of corporate bond returns. Our framework features time-varying macroeconomic uncertainty and generalized disappointment aversion. The model yields three downside risk factors versus one documented in the empirical literature. We find that our factors are able to explain the cross-sectional variation of corporate bond returns both at the individual bond- and portfolio-level. Our factors provide significant explanatory power beyond other established factors in the literature. Moreover, we find that volatility downside risk matters, while pure volatility risk is marginally significant. Last, we show that our three downside risk factors subsume the documented predictability of the Bai, Bali, and Wen (2019) downside risk factor.

Volatility and the cross-section of corporate bond returns

This paper examines the pricing of volatility risk and idiosyncratic volatility in the cross-section of corporate bond returns for the period of 1994–2016. Results show that bonds with high volatility betas have low expected returns, and this negative relation appears in all segments of corporate bonds. Further, bonds with high idiosyncratic bond (stock) volatility have high (low) expected returns, and this relation strengthens as ratings decrease. Conventional risk factors and bond/issuer characteristics cannot account for these cross-sectional relations. There is evidence that the effect of idiosyncratic stock volatility on expected bond returns works through the channel of contemporaneous stock returns.

Switching Perspective: Corporate Distress, Asset and Financial Risk, and the Cross-Section of Bond Returns

We offer evidence suggesting a significantly negative relation between firm-level distress risk and the cross-section of corporate bond returns, analogous to the often negative relation between distress risk and stock returns found in prior studies (distress anomaly). Our evidence casts doubts on theories arguing that the distress anomaly arises due to shareholders shifting financial risk onto debtholders in distress. In accordance, proxy variables suggested by such theories do not condition the distress risk-bond return relation. More promising, however, are theories suggesting that the anomaly arises due to distressed firms having a low levered asset risk due to them owning valuable disinvestment options, with some of the proxy variables suggested by these theories conditioning the former relation.

Investor Sentiment and the Cross-Section of Corporate Bond Returns

This paper constructs an investor sentiment measure at both individual bond and aggregate levels, uncovering the first evidence that investor sentiment has strong predictive power for the entire cross-section of corporate bond returns. We find that high bond investor sentiment leads to low future returns. A portfolio that longs low sentiment bonds and shorts high sentiment ones generates an average monthly return of 0.64% for high-quality bonds, and 1.57% for speculative-grade bonds. The results are robust to controlling for various risk factors and bond characteristics. The cross-sectional predictability of bond returns is countercyclical, and appears to stem from its predictive power for macroeconomic conditions.

RETRACTED: Common risk factors in the cross-section of corporate bond returns

Abstract We investigate the cross-sectional determinants of corporate bond returns and find that downside risk is the strongest predictor of future bond returns. We also introduce common risk factors based on the prevalent risk characteristics of corporate bonds—downside risk, credit risk, and liquidity risk—and find that these novel bond factors have economically and statistically significant risk premiums that cannot be explained by long-established stock and bond market factors. We show that the newly proposed risk factors outperform all other models considered in the literature in explaining the returns of the industry- and size/maturity-sorted portfolios of corporate bonds.

Reach for Safety

In the corporate bond market, investor propensity to reach for yield creates an opportunity for factor-based investors to “reach for safety” following an economic intuition that parallels low-risk factor investing in equities. Given this insight, the authors develop a measure of credit safety based on the Merton [1974] distance-to-default variable, which they use to define quality and value factors. They demonstrate that both factors help explain the cross-section of corporate bond returns in an uncorrelated and complementary manner. Since these factors have performed particularly well in their bottom quintiles, the authors demonstrate how they can be used as screens within long-only portfolios. In addition, they show how incorporating their quality and value insights in a long-only optimization setup can generate significant outperformance net of estimated transaction costs versus traditional value-weighted market portfolios.

Breadth of Ownership and the Cross-Section of Corporate Bond Returns

We investigate the effects of short sale constraints on asset mispricing in the corporate bond market. Consistent with Miller (1977)’s theory that short sale constraints can lead to asset overpricing, we document a significant positive relation between changes in ownership breadth (a proxy for short sale constraints) and the cross-section of future corporate bond returns. The return predicative power of changes in breadth is shown to be relatively short-lived in the corporate bond market, possibly due to the bounded upside payoffs of debt. Further analysis shows that the return predictability of changes in breadth is stronger among bonds with higher credit risk and during periods of high investor sentiment, and is mainly driven by bond overpricing rather than underpricing. Overall, the impact of short sale constraints on bond mispricing appears to be more pronounced when overpricing is more likely.

Reach for Safety

In the corporate bond market, investor propensity to reach for yield creates an opportunity for factor-based investors to “reach for safety” following an economic intuition that parallels low-risk factor investing in equities. Given this insight, we motivate a measure of credit safety based on the Merton (1974) distance-to-default variable, which we use to define quality and value factors. We demonstrate that both factors help explain the cross-section of corporate bond returns in an uncorrelated and complementary manner. Since these factors have performed particularly well in their bottom quintiles, we demonstrate how they can be used as screens within long-only portfolios. In addition, we show how incorporating our quality and value insights in a long-only optimization setup can generate significant outperformance net of estimated transaction costs versus traditional value-weighted market portfolios.

Explaining and Benchmarking Corporate Bond Returns

We evaluate how different betas and characteristics related to default, term, and liquidity risk fare against one another in explaining the cross-section of corporate bond returns. We find that characteristics – credit rating, duration, and Amihud illiquidity measure–fare better. Yields add incremental explanatory power. Consistent with yields providing a timelier assessment of default risk than ratings, bonds with higher yields but similar credit ratings, durations and Amihud measures experience more subsequent ratings downgrades, fewer upgrades, and a higher frequency of defaults. Based on our findings, we present characteristic portfolios that can be used to benchmark individual bond and portfolio returns.

Short Selling and the Cross-Section of CorporateBond Returns

This article studies the effect of short selling in the equity market on corporate bond returns. We show that firms with heavily shorted shares or large short-trade sizes experience significantly negative future bond returns. Further tests indicate that the relationship between short-trade size and subsequent bond returns is more consistent with stealth trading of short sellers. The impact of short selling on bond returns is robust to various controls for risk, liquidity, and other pricing factors. In examining the information source of short selling, we find that firms associated with heavy shorting activities or large short-trade sizes are likely to subsequently experience negative earnings surprises, higher credit risk, and reduced dividends. The evidence provides little support for the overvaluation argument. Overall, the results are consistent with the proposition that short trades in the equity market exert important valuation consequences in the corporate bond market.

Do Distributional Characteristics of Corporate Bonds Predict Their Future Returns?

We find a significantly positive (negative) relation between volatility (skewness) and the cross-section of corporate bond returns, whereas kurtosis does not make a robust incremental contribution to the predictability of future bond returns. The risk-adjusted return spreads in volatility (skewness) sorted portfolios represent compensation for differences in the level of idiosyncratic volatility (idiosyncratic skewness) and differential exposure to the common idiosyncratic volatility factor in the bond market. We also show that the new risk factors based on the distributional moments of bond returns represent an important source of common return variation missing from the long-established stock and bond market factors.