Bond-Market Risk Factors and Manager Performance

Abstract

The authors introduce a novel approach for jointly testing bond-market factor models and bond manager performance using the attributes of market efficiency as an ideal, or benchmark. In addition to proposing enhanced constructions of term and default factors, they find evidence for a prepayment risk factor. They also find that style premiums do not materially reduce alphas or explain much additional common variation in the returns of traded bond portfolios when they are added to term, default, and prepayment risk factors. A factor model with just term, default, and prepayment risk factors performs as well, but is more parsimonious and employs clear sources of systematic risk. The authors find evidence of factor-adjusted alpha in a very small subset of active bond managers.