Bridge over ocean
15 August 2019 CFA Institute Journal Review

Common Risk Factors in the Cross-Section of Corporate Bond Returns (Digest summary)

  1. Servaas Houben, CFA

Interest in corporate bonds has risen because of new issuance and demand from institutional investors. The authors show that downside risk is an important indicator for future bond returns and that such other risk factors as credit and liquidity risk have significant risk premiums as well. When these new explanatory variables are added, previous models are outperformed, and thus, institutional investors should include these factors when performing risk–return analysis.

What Is the Investment Issue?

Equity and corporate bond risk premiums have several similarities, including that (1) the value of both assets depends on the value of the underlying asset and (2) corporate bond default risk changes with the equity price. There are also important differences: Credit risk is an important driver for corporate bond returns because of legal factors. Also, corporate bondholders are more sensitive to downside risk than stockholders and are often institutional investors. Moreover, the corporate bond market is less liquid than the equity market, and finally, there is evidence for differences in corporate bond and equity return premiums.

Compared with stock market return research, there is limited cross-sectional research on common risk factors explaining corporate bond returns. Instead of using aggregate variables, the authors use transactional data and unique individual corporate bond characteristics to explain bond returns. They introduce new factors that turn out to be statistically significant.

How Did the Authors Conduct This Research?

The authors merge the TRACE dataset with the Mergent fixed-income securities database (FISD). They remove unlisted securities, structured and asset-backed securities, and convertible bonds; bonds with a price above or below a certain threshold; floating coupon rate bonds and bonds with less than one year to maturity,; cancelled transactions; bonds with special sales conditions; and daily trading volume below a certain threshold. Their final sample consists of 1.24 million observations between July 2002 and December 2016.

The authors also assess the predictive power of downside risk for future corporate bond returns. Instead of using downside beta as a parameter for downside risk, they use the 5% value at risk (VaR) metric. For credit risk, they use the Mergent FISD to collect historical ratings. When both Standard & Poor’s (S&P) and Moody’s Investors Service ratings data are available, the average of these ratings is used as the credit rating. For the bond market beta, the authors use the difference between the value-weighted average bond returns and the one-month Treasury bill rate.

The authors include the new risk factors in their model and assess the explanatory significance of those factors. They compare their model with other existing models based on two sets of empirical test portfolios and show that their four-factor model provides more explanatory power than other models.

The authors use transactional data to derive bond-implied risk factors. They focus on corporate bond returns and not spreads, unlike previous researchers.

What Are the Findings and Implications for Investors and Investment Professionals?

The authors show the following:

  1. Bond beta is positively related with rating and illiquidity, and smaller bonds have a higher VaR and less liquidity.
  2. The empirical distribution of bonds is skewed and has fat tails and thus does not reflect a normal distribution.
  3. Corporate bonds with the highest VaR have higher returns, but these bonds also have higher market beta, lower liquidity, and higher credit risk.
  4. Downside risk and liquidity have a greater effect on future bond returns than credit and market risk
  5. The short-term reversal (one-month-lagged return) effect is significant.
  6. Volatility contributes most to downside risk premium.

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