Pricing Errors, Behaviour Bias, and Bond Return Predictability

Abstract

The pricing error (PE) from the instrumented principal component analysis (IPCA) model
of Kelly, Palhares, and Pruitt (2023) negatively predicts corporate bond returns in the cross-section.
A long-short PE portfolio generates an average monthly return of 1.50%, a much greater magnitude of predictability than previously documented. The predictability is robust to controlling for bond and stock risk factors and characteristics, and to using different return measures and model specifications. We further find that the PE level is positively related to uncertainty, suggesting that limited investor participation and biased reactions to information are plausible economic drivers of the PE predictive power.

Keywords: Pricing error; risk factors; cross-section; bond return predictability

JEL Classification: G12; G14