The Market Risk of Corporate Bonds

Abstract

Although the capital asset pricing model (CAPM) was, at its origin, intended for all tradeable assets, it is rarely applied to bonds. Rather than appraising risk with respect to a market portfolio, bond portfolio managers rely on directly observable measures. The authors build a model for corporate bonds that stands close to this practice in that it converts ad hoc risk appraisals into a singular variance forecast. The model provides as such a pertinent definition of corporate bond market risk. The model sheds new light on an ongoing debate over which factors to focus on in a corporate-bond investment. Equity-style factors are being proposed, such as size, value, and momentum, which are tested in an off-key CAPM framework. The authors’ model gives insight into how these factors accord with the conventional risk measures.

TOPICS: Fixed-income portfolio management, analysis of individual factors/risk premia, factor-based models

Key Findings

• • Bond factor investing remains underdeveloped compared to equity factor investing, the reason being that the notion of bond factors is unclear—more precisely, it is not clear where market risk ends and factor risk starts.

• • We build a risk model that marks the divide between systematic market risk and style factor risk for corporate bonds.

• • We provide evidence that the bond style factors proposed to date are ambiguous. Their outperformance is largely due to active market bets, not style bets.