Fixed Income

Give Credit Where Credit Is Due: What Explains Corporate Bond Returns?

Topics - Fixed Income

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Give Credit Where Credit Is Due: What Explains Corporate Bond Returns?

This paper explains the risk and returns of U.S. corporate bond indices using a set of economically-motivated factors and finds that options markets explain a great deal of credit returns. Two features of corporate bonds generate option exposure. The first is that, in accordance with the Merton model, a corporate bond is economically equivalent to a short put option on a firm’s assets bundled with a risk-free bond. The second is that many corporate bonds include call provisions, which are basically options granted to the bond issuer. Thus, callable corporate bonds are positively exposed to firm asset values and negatively exposed to interest rates, firm volatility, and bond volatility. Using data spanning 21 years, we find that these identified risk factors explain between 60% and 76% of the return variability of the aggregate U.S. investment grade corporate index, its sub-indices by maturity, and the aggregate U.S. high yield index.

We further decompose performance to identify systematic and idiosyncratic exposures. Systematic exposures compensate bond investors via the bond, equity, equity volatility, and bond volatility risk premia. Idiosyncratic exposures, on the other hand, provide risk without reward on average. Finally, the paper proposes a Risk-Efficient Credit strategy that isolates the compensated risk premia by buying bonds and equities and by selling delta-neutralized equity index options and bond options. Risk-Efficient Credit strategies had similar or higher average returns than their corporate bond index counterparts, despite realizing between 15% and 48% lower volatility as well as attenuated drawdowns.


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The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

 

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