Modeling Corporate Bond Returns

We propose a conditional factor model for corporate bond returns with five factors and time-varying factor loadings. We have three main empirical findings. First, our factor model excels in describing the risks and returns of corporate bonds, improving over previously proposed models in the literature by a large margin. Second, our model recommends a systematic bond investment portfolio whose high out-of-sample Sharpe ratio suggests that the credit risk premium is notably larger than previously estimated. Third, we find closer integration between debt and equity markets than found in prior literature.