Return Decompositions: Evidence from the Corporate Bond Market



This paper presents a log linearization for corporate bond returns in the same spirit as Campbell and Shiller (1988). I show that despite the finite  maturity of corporate bonds, present value estimation techniques carry over from the equity market to corporate bond markets. Using these results, I decompose unexpected corporate bond returns into cash flow and discount rate news. I show that during normal times, discount rate news is an important component of corporate bond (excess) return variance. During the financial crisis of 2007 to 2009, it is the most dominant component by far. Finally, I show analytically that discount rate news compromises capital adequacy of banks with large positions credit risky instruments that have an available-for-sale accounting purpose. The reason is that no capital is held for discount rate news shocks while they do affect capital ratios in a similar fashion as losses.
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Sebastian Gryglewicz
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