Implied Volatility Changes and Corporate Bond Returns

Abstract

Option implied volatility change has significant cross-sectional predictive power for the underlying firms’ bond returns. Corporate bonds with large increases in implied volatilities over the past month underperform those with large decreases in implied volatilities by approximately 0.6% per month. The results are robust to various bond characteristics and volatility related variables, as well as to stock and bond factor models. Our results are consistent with the notion that informed traders with new information about default risk prefer to trade in the option market, and that the corporate bond market is slow in incorporating that information.

Keywords: Corporate bonds, implied volatility changes, default risk, information diffusion

JEL Classification: G10, G12, G14