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 premia 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.

Keywords: corporate bond, risk factors, downside risk, credit risk, liquidity risk

JEL Classification: G10, G11, C13