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Downside variance premium, firm fundamentals, and expected corporate bond returns

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  • Huang, Tao
  • Jiang, Liang
  • Li, Junye

Abstract

We find a strong and robust positive relationship between individual downside variance premia (DVP)–the difference between risk-neutral and physical expected downside variances–and future corporate bond returns. The spread portfolio that longs the high DVP bond portfolio and shorts the low DVP bond portfolio earns a statistically significant excess return of 0.37% (0.42%) per month in value- (equal-)weighted returns. The alpha estimates from various factor models remain statistically significant and economically substantial. The predictive power of the downside variance premium is stronger in noninvestment-grade (long-maturity) corporate bonds than in investment-grade (short-maturity) bonds. We show that the downside variance premium positively relates to the likelihood of future default and cash flow uncertainty and negatively relates to future cash flows.

Suggested Citation

  • Huang, Tao & Jiang, Liang & Li, Junye, 2023. "Downside variance premium, firm fundamentals, and expected corporate bond returns," Journal of Banking & Finance, Elsevier, vol. 154(C).
    • Handle: RePEc:eee:jbfina:v:154:y:2023:i:c:s0378426623001516
    DOI: 10.1016/j.jbankfin.2023.106946
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    More about this item

    Keywords

    Corporate bond return predictability; Equity options; Downside variance premium; Probability of default; Credit rating downgrade; Cash flow uncertainty;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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