Modeling Corporate Bond Returns
52 Pages Posted: 14 Dec 2020 Last revised: 29 Dec 2020
Date Written: December 1, 2020
Abstract
We propose a new conditional factor model for returns on corporate bonds. The model has four factors with time-varying factor loadings that are instrumented by observable bond characteristics. We have three main empirical findings. The first is that our factor model excels in describing the risks and returns of corporate bonds, improving over previously proposed models in the literature by a large margin. Second, using bond characteristics to instrument evolving bond risk exposures significantly improves not only our model, but also previously proposed models of observable corporate bond factors. Third, our no-arbitrage model recommends a systematic bond investment portfolio that significantly outperforms leading corporate credit investment strategies. However, also we find that a ``pure alpha'' bond portfolio---which is orthogonal to factor risk---is incrementally profitable when combined with the no-arbitrage strategy.
Keywords: corporate bond, factor model, bond portfolio, credit risk, IPCA
JEL Classification: G10, G11, G12
Suggested Citation: Suggested Citation
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