Investigating the drivers of corporate bond factors

In a more liquid sample, we evaluate the ability of corporate bond risk factors to generate alpha. Extreme downside risk and illiquidity risk exhibit predictive power for future total returns (in excess over the one-month T-bill). Investigating their drivers and controlling for credit risk, both factors’ cross-sectional relation declines into statistical insignificance. Extending the analysis to credit returns (in excess over duration-matched Treasuries)yields statistically and economically insignificant findings. Thus, the predictive power of total returns is driven by interest rates. We propose an enhanced return estimation methodology and alternative signals as we recognise pitfalls in previous literature. Wes how that short-term reversal has a substantially stronger performance when constructed credit risk-neutral. However, findings are driven by limits to arbitrage and disappear with a one-trade implementation lag