Duration-Based Valuation of Corporate Bonds

Abstract

We decompose corporate bond and equity index returns into duration-matched government bond returns and the excess returns over this duration-matched counterfactual, which we term duration-adjusted returns. Our decomposition leads to markedly different return patterns and asset pricing implications compared to previously used excess return definitions (i.e., returns in excess of Treasury bills). In particular, we find that investment-grade bonds earn a small credit risk premium, comparable in magnitude to the convenience yield, and that duration adjustment resolves the CAPM's failure to price corporate bonds. These findings highlight the importance of adjusting for non-stationary interest rate environments in asset pricing tests.

Keywords: corporate bonds, duration, capital asset pricing model

JEL Classification: G12