Finding value in the U.S. corporate bond market
67 Pages Posted: 5 Jun 2024
Date Written: June 03, 2024
Abstract
This paper identifies value-investing opportunities in the U.S. corporate bond market through the joint construction of a bond valuation model and a return factor model. The valuation model explains the cross-sectional corporate bond yield variation with a flexible functional form in bond risk characteristics including bond duration, credit rating, historical yield change volatility, bond liquidity, and the optionality-induced yield spread adjustment for callable bonds. The return factor model embeds the residual from the valuation model as a mispricing factor while capturing the stronger co-movements between bonds from the same industry, similar rating classes, and similar duration segments, and accounting for differential pricing of bond return risk, liquidity cost, and the optionality exposure. Historical analysis over the past two decades shows that the valuation model can explain the cross-sectional bond yield variation very well, and the value-investing portfolio constructed from the return factor model generates highly positive average excess returns with low risk.
Keywords: bond yields, credit risk, duration risk, historical volatility, liquidity cost, optionality, mispricing, value investing
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