Is the Cross-Section of Expected Bond Returns Influenced by Equity Return Predictors? September 6, 2014
Tarun Chordia
Amit Goyal
Yoshio Nozawa
Avanidhar Subrahmanyam
Qing Tong
Abstract
Using a comprehensive cross-section and time-series of corporate bond returns assembled from multiple data sources, we analyze whether commonly analyzed equity return predictors also predict bond returns. There is a surprisingly strong monthly lead from equity to bond returns, indicating that new information gets reflected in the equity market first. In univariate portfolio sorts, net equity issues are positively priced in the bond market, consistent with the notion that equity is preferred when bond market is undervalued. Profitability is negatively priced while idiosyncratic equity volatility is positively priced in the corporate bond market, suggesting that profitable and relatively less volatile firms are more attractive to bond investors, thus requiring lower returns. Our results indicate that the bond markets do price risk, but also are susceptible to delayed information transmission relative to equities. Finally, consistent with a relatively sophisticated institutional clientele, bonds are efficiently priced in that none of the behaviorally-motivated variables predict returns after accounting for transactions costs, though some risk-based variables continue to do so.
Is the Cross-Section of Expected Bond Returns Influenced by Equity Return Predictors?
Firms finance their assets by a mixture of debt and equity claims. As per the risk-reward (RR) paradigm exposited in neoclassical asset pricing models, the required return on a firm represents a reward for risk borne by investors in the firm and is the weighted average of the expected returns on debt and equity components. Some recently documented predictors of average equity returns are hard to rationalize in the context of the RR paradigm, and seem to represent anomalous deviations from the paradigm. Thus, for example, the predictive power of accounting accruals and earnings surprises has been attributed to limited attention (Hirshleifer and Teoh (2003); Hirshleifer, Lim, and Teoh (2011)). Short-term (monthly and weekly) reversals documented by Jegadeesh (1990) and Lehmann (1990) have been attributed to overreaction (Cooper (1999)) while predictability due to longer-term returns has been motivated by the psychological biases of overconfidence and self-attribution (Daniel, Hirshleifer, and Subrahmanyam (1998)) as well as the conservatism bias and the representativeness heuristic (Barberis, Shleifer and Vishny (1998)). Other anomalies include asset growth, new equity issues, profitability, and idiosyncratic volatility.
While a voluminous literature documents anomalies in equities (see Harvey, Liu, and Zhu (2013) for an excellent summary), there is as yet only limited evidence for the existence of such anomalies in the bond market. We fill this void by empirically examining whether variables capturing equity return anomalies also forecast corporate bond returns. We note that there are a few arguments for why analogs of equity anomalies might or might not exist in the bond market: (1) Both bond and stock market investors have cognitive biases that are reflected in both the stock market and the bond market, and arbitrage is partially effective.1 (2) Bond market investors have Edwards, Harris, and Piwowar (2007) show that on average bonds trade on only 53% of the days cognitive biases, and arbitrage is completely ineffective. (3) Bond market investors are quite sophisticated, leading to a bond market free of anomalous behavior. The three situations above have different implications for the statistical and economic significance of anomalies. In Case (1) we expect statistically significant anomalies which disappear net of transaction costs, in Case (2) we expect anomalies that are profitable net of transaction costs, while in Case (3) we expect no discernible anomalies at all.
One reason that investor biases may not manifest themselves in the corporate bond market is because this market is dominated by institutions, and Barber et al. (2009) suggest that institutions tend to be more sophisticated than individuals. Indeed, Edwards, Harris, and Piwowar (2007) document a median trade size of $632,700 in the corporate bond market, and find that in the corporate bond market transaction costs are lower for larger trades suggesting that institutions are likely to be the typical traders in bonds. While this a priori reasoning is suggestive that the market for corporate bonds may in fact be more efficient than that for stocks, our empirical tests are able to shed specific light on which of the three cases above is supported by the data.
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