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Issuer Quality and Corporate Bond Returns

  • Robin Greenwood

    ()

    (Harvard Business School, Finance Unit)

  • Samuel G. Hanson

    ()

    (Harvard University)

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    Changes in the pricing of credit risk disproportionately affect the debt financing costs faced by low credit quality firms. As a result, time-series variation in the average quality of debt issuers may be useful for forecasting excess corporate bond returns. We show that when issuance comes disproportionately from lower quality borrowers, future excess returns on high yield and investment grade bonds are low and often significantly negative. The degree of predictability is large in both economic and statistical terms, with univariate R2 statistics as high as 30% at a 3-year horizon. The results are difficult to reconcile with integrated-markets models in which the rationally determined price of risk fluctuates in a countercyclical fashion. The results can be partially explained by models in which shocks to intermediary capital or agency problems drive variation in required returns. Finally, we consider models in which investor over-extrapolation plays a role and find some evidence in favor of these models.

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    Paper provided by Harvard Business School in its series Harvard Business School Working Papers with number 11-065.

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    Length: 67 pages
    Date of creation: Jan 2010
    Date of revision:
    Handle: RePEc:hbs:wpaper:11-065
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