Pricing Corporate Bonds with Credit Risk Primitives
81 Pages Posted: 9 May 2024
Date Written: May 9, 2024
Abstract
This paper introduces a novel corporate bond risk factor exploiting the interaction between credit spreads and bond duration, generating a large risk-premium even after controlling for market risk and transaction costs. We propose a parsimonious three-factor model incorporating this factor alongside the Treasury and corporate bond market factors, outperforming more complex multi-factor models. The new factor is driven by default news and risk premium news. The factor falls when defaults unexpectedly rise and when the market risk premium falls, providing a unified explanation for the various corporate bond anomalies associated with tail and credit risk.
Keywords: Corporate Bonds, Factor Model, Fixed-Income Securities, Credit Risk
JEL Classification: G12, G13
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