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23 January 2020 CFA Institute Journal Review

Volatility and the Cross-Section of Corporate Bond Returns (Summary)

  1. Marc L. Ross, CFA

This is a summary of "Volatility and the Cross-Section of Corporate Bond Returns," by Kee H. Chung, Junbo Wang, and Chunchi Wu, published in the Journal of Financial Economics.

Corporate bond returns capture priced-in volatility risk and unique volatility for all types of corporate bonds. Those bonds evidencing high idiosyncratic volatility produce high returns. As their creditworthiness decreases, these bonds’ returns are greater still.

What Is the Investment Issue?

Investment scholarship has accorded relatively little attention to asset returns’ sensitivity to volatility risk. Similarly, finance academia has widely researched how idiosyncratic or unique volatility affects expected returns on equities but much less so for corporate fixed income. Although both stocks and bonds may capture cash flows from the same company, each type of security has unique features causing their returns to respond differently to external volatility.

Few studies have pursued whether volatility risk is captured in the cross-section of asset returns. The authors note, “While these papers study the determinants of yield spreads, our paper focuses on the pricing of aggregate volatility risk and idiosyncratic volatilities in the cross-section of expected bond returns.”

How Did the Authors Conduct This Research?

The authors review corporate bond data from the National Association of Insurance Commissioners (NAIC) database, the enhanced Trade Reporting and Compliance Engine (TRACE) database, and Mergent’s Fixed Investment Securities Database (FISD). The latter database helps the authors winnow down the sample by excluding non-USD-denominated bonds; asset-backed bonds; any bonds with such optionality features as call provisions, conversion options, or sinking fund provisions; and bonds with maturities of less than 1 year or greater than 30 years. The final sample for evaluation considers 13,264 bonds issued by 2,309 firms from January 1994 to December 2016.

The authors investigate the presence of volatility risk in the cross-section of expected bond returns, controlling for the effects of liquidity, liquidity risk, bond and issuer characteristics, analyst coverage, institutional ownership, and ratings. Subsample analysis includes bonds and bond transactions of health maintenance organizations (HMOs) and insurers contained in the NAIC database and also examines whether risk and return features differ from those in the TRACE data. Robustness tests help to separate volatility from a number of cross-sectional effects to eliminate such exogenous economic factors as liquidity and information frictions, types of clients, rating opinions, leverage, and other bond and firm characteristics. Idiosyncratic bond volatility is a separate and distinct type of risk that is reflected in the cross-section of expected bond returns.

The authors’ findings are robust to subsample analysis, confirming the negative correlation between bond returns and Volatility Index (VIX) betas.

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

The authors demonstrate that volatility risk permeates all types of corporate bonds. Those with a lower credit rating and more exposure to this type of risk carry a greater volatility risk premium. Additionally, idiosyncratic bond volatility correlates positively with a firm’s lack of creditworthiness. Idiosyncratic volatility is a separate and distinct type of risk reflected in expected bond returns. Finally, companies that evidence high idiosyncratic stock volatility produce lower expected bond returns. The authors’ findings are robust to a wide range of controls, including bond and firm characteristics, institutional ownership, exposure to aggregate volatility, illiquidity, liquidity risk, and credit quality.

The authors’ conclusions are particularly relevant to the work of global risk officers, pension fund trustees, fixed income analysts, product managers, investment and derivatives strategists, and portfolio managers. Because risk assessment is crucial to asset management, a greater understanding of its determinants and the extent of its presence in the corporate bond market can be integral to the investment decision-making process.

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