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U.S. Corporate Bond Index Return Model

Posted in Bonds

Is there a straightforward way to model the returns on U.S. Corporate bond indexes? In his April 2019 paper entitled "Give Credit Where Credit is Due: What Explains Corporate Bond Returns?", Roni Israelov models returns on these indexes based on four intuitive factors:

  1. Positive exposure to government bond yields, quantified via duration-matched government bonds.
  2. Negative exposure to rate volatility from bond call provisions (uncertainty in duration), quantified via delta-hedged options on 10-year Treasury note futures.
  3. Positive exposure to firm values due to default risk, quantified via index constituent-weighted equities.
  4. Negative exposure to firm stock volatility due to default risk, quantified via index constituent-weighted delta-hedged single-name equity options.

Exposures 1 and 2 are general (systematic), while exposures 3 and 4 contain both systematic and firms-specific (idiosyncratic) components. He tests this 4-factor model on six Bank of America Merrill Lynch U.S. corporate bond indexes: Investment Grade, High Yield, 1-3 Year Corporate, 3-5 Year Corporate, 5-10 Year Corporate, and 10+ Year Corporate. All duration-specified indexes are investment grade. He also tests two Credit Default Swap (CDS) indexes: investment grade and high yield. He further devises and tests a Risk-Efficient Credit strategy on the six bond indexes that isolates and exploits compensated risk premiums by buying bond index futures, buying equity index futures, selling delta-hedged equity index options and selling delta-hedged options on bond index futures, with allocations sized to match respective historical exposures of each index. Using monthly data for the eight bond/CDS indexes and the four specified factors and their components during January 1997 through December 2017, he finds that:

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