Downside Risk and the Cross-section of Corporate Bond Returns

We rationalize in a theoretical framework the empirically documented importance of volatility and downside risk in the cross-section of corporate bond returns. Our framework features time-varying macroeconomic uncertainty and generalized disappointment aversion. The model yields three downside risk factors versus one documented in the empirical literature. We find that our factors are able to explain the cross-sectional variation of corporate bond returns both at the individual bond- and portfolio-level. Our factors provide significant explanatory power beyond other established factors in the literature. Moreover, we find that volatility downside risk matters, while pure volatility risk is marginally significant. Last, we show that our three downside risk factors subsume the documented predictability of the Bai, Bali, and Wen (2019) downside risk factor.