Decomposing the Returns on European Debt

Common variation in the prices of European corporate debt may not always be associated with a rational response to an increase in the relative importance of a macroeconomic risk factor. Building on Campbell’s ICAPM framework, we show that risk premia of assets with nonlognormal return distributions represent compensation not only for exposure to macroeconomic factors but also for unexpected revisions to these assets’ return distributions, such as sudden increases in the likelihood of extreme events. If such revisions happen across assets almost simultaneously, perhaps as a systemic response to a large credit event, they can induce covariation in risk premia unrelated to the time variation of the priced macroeconomic factors. Our study presents evidence from the European debt markets which supports this theory. The asset pricing tests also document patterns consistent with the “flight to quality” effect for European corporate bonds.