The Cross-Section of Bond Returns

1 CE Credit | 2 Papers (54 Pages Total)

The two-paper study covers the cross-section of expected returns for global corporate bonds and US municipal bonds, respectively. We show that there is a reliable relation between current forward rates and future corporate bond returns, and between yields and future municipal bond returns. In the corporate bond paper, we also tested 12 alternative variables and found that they don’t contain additional information about future corporate bond returns after we control for forward rates. The only exception is the past short-term equity return. In the municipal bond paper, we identify the three main drivers of higher expected returns: tax clientele effects, term premiums, and credit premiums. We also propose a framework to design a systematic municipal bond strategy that emphasizes all three drivers while considering portfolio diversification and turnover.

Learning Objectives

1. Understand why investors can use forward rates to estimate expected corporate bond returns and yields for municipal bonds.

2. Review the tests and the results regarding alternative variables and their lack of additional information with respect to future corporate bond returns.

3. Understand the difference between information contained in forward rates and what short-term equity returns tell us about future corporate bond returns.

4. Evaluate the tax clientele effect in municipal bonds.

5. Consider whether term spreads and credit spreads predict future term premiums and credit premiums in municipal bonds.

6. Learn how a systematic municipal bond strategy can help incorporate all the drivers of higher expected returns while taking diversification and turnover into consideration.

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