Consumer Behaviour,Economics & Finance

A simple way to predict bond yields

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A new study proposes an easier method to forecast corporate bond premiums: Just consider long-run consumption growth, instead of a complex mix of various factors

By Putro Harnowo, Senior Content Manager, China Business Knowledge @ CUHK

The first week of 2024 was welcomed by a thriving debt market with almost US$60 billion in bond issuance, and America’s “Big Six” banks are expected to dominate the market. The previous year has also seen pharma giant, Pfizer, raised US$31 billion through its largest debt offering, confirming what the analysts dubbed a “bond binge”.

Despite the increasing traction, bonds are not traditionally as well-known as stocks to raise capital. Unlike stocks, which represent ownership in a company, bonds function as a form of loan provided by investors. While small companies often turn to banks for borrowing funds, big multinationals like Apple, McDonald’s, and Walmart opt to issue billions of bonds to fuel their expansive operations.

Similar to stocks, bonds can be traded on the primary market, where new bonds are sold directly by the issuing company, and on the secondary market, where bonds are traded among investors. As holding bonds comes with various risks, investors are receiving additional yields as compensation called corporate bond premiums or risk premiums.

This return is influenced by various factors, such as interest rates, creditworthiness of the issuing company, supply and demand dynamics, and overall market conditions. However, a new study suggests a simpler way to predict premiums.

corporate bonds
Like stocks, bonds can be traded on the primary market and the secondary market.

“There are a lot of factors out there that can explain corporate bond premiums, but if there is one factor that can explain a large variation in corporate bond premiums, why do we need all of these proposed factors?” says Jo Chanik, Assistant Professor at the Department of Finance of The Chinese University of Hong Kong (CUHK) Business School.

In a paper titled A one-factor model of corporate bond premia, Professor Jo, along with the University of Toronto’s Professor Redouane Elkamhi and Professor Yoshio Nozawa, tried to propose a simplified approach to understanding the risk premiums associated with corporate bonds. Specifically, the model addresses the complexities by focusing on a single factor, namely long-run consumption growth.

“We find that this single-factor model can explain a large cross-sectional variation in bond risk premiums across different types of corporate bonds. It turns out that this macro-fundamental-based factor is so powerful that we do not need to consider numerous other factors.”

One factor to see all

The researchers constructed their one-factor model after analysing a wide range of bond characteristics from 1973 to 2019. They examined factors such as credit spreads, credit ratings, downside risk, idiosyncratic volatility, and long-term reversals. Additionally, they explored the relationship between bond returns and consumption growth.

The researchers accumulated consumption growth for six years and calculated the covariance between portfolio returns to measure long-run consumption risk. This factor is based on the idea that the overall trend of consumption growth can influence the risk premiums demanded by investors for holding corporate bonds.

Specifically, when the economy is growing and stable, households and businesses tend to be optimistic about the future, leading to increased consumption and investment activities. Conversely, during periods of uncertainty or recession, consumption growth may slow down or even decline. Bonds that exhibit a strong positive relationship with long-term consumption growth may be perceived as more risky and consequently offer higher premiums, while bonds showing weaker alignment with consumption growth may command lower risk premiums.

“There are a lot of factors out there that can explain corporate bond premiums, but if there is one factor that can explain a large variation in corporate bond premiums, why do we need all of these proposed factors?”

Professor Jo Chanik

From an investment perspective, the long-run consumption growth factor provides a framework for understanding how economic trends and consumption patterns influence the risk-return tradeoff in corporate bond investments.

“The use of a simplified yet comprehensive approach has implications for understanding bond risk premiums. It provides a streamlined framework that is easier to interpret and implement compared to more complex models,” says Professor Jo.

“This simplicity can be advantageous for investors, financial institutions, and policymakers who seek a clear understanding of the factors driving corporate bond risk premiums. It allows them to assess and compare the risk-return characteristics of different bonds based on a common factor, facilitating investment decision-making and risk management practices.”

How does it work?

To use this model, investors could sort the corporate bonds into different portfolios based on their credit rating, credit spreads, downside risk, idiosyncratic volatility, long-term reversals, maturity, and sensitivity. The investors then estimate the risk premium for each portfolio based on the estimated risk-aversion coefficient and the covariance between portfolio returns and consumption growth.

corporate-bonds
The one-factor model estimates risk premiums for portfolios based on investor risk aversion and the covariance between portfolio returns and consumption growth.

The one-factor model would estimate the risk premium for each portfolio based on the level of risk aversion among investors and the covariance between portfolio returns and consumption growth. The model might predict that the high credit rating portfolio has a lower risk premium because it is considered less risky, while the low credit rating portfolio has a higher risk premium because it is considered riskier.

“The one-factor model of corporate bond premiums can have practical applications in various areas. For investors, it can inform their bond selection process by providing insights into the risk premiums associated with different bond characteristics such as credit rating, credit spreads, downside risk, and others, so they can optimise their investment portfolios considering a single factor,” says Professor Jo.

By developing a simple yet powerful model for predicting bond returns and exploring the relationship between bond returns and consumption growth, the researchers have provided valuable insights that have the potential to inform investment decisions and contribute to a deeper understanding of financial markets.

“Financial institutions can incorporate the model’s findings into their risk management frameworks to assess the risk exposures of their corporate bond portfolios more effectively,” Professor Jo adds. “Policymakers can benefit from the model’s insights to monitor and analyze trends in the corporate bond market and make informed regulatory decisions to ensure market stability.”

Not one-size-fits-all solution

Despite the promising findings, Professor Jo acknowledges potential challenges in implementing a one-factor model in real-world investment and financial decision-making contexts. “The model makes certain simplifying assumptions and may not capture all the complexities and nuances of the corporate bond market,” he says. “It relies on historical data and statistical techniques to estimate risk premiums, which may not fully reflect future market dynamics.”

“Given the fast and unpredictable pace of change in the world we live in, it is hard to predict whether our one-factor model will continue to be as powerful as it has been in the past. Additionally, the model’s performance may vary under different economic conditions or during periods of market stress, which could limit its effectiveness as a standalone tool for decision-making.”

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Admittedly, the one-factor model of corporate bond premium has limitations that open avenues for future research. It represents a simplified view of risk premiums and may not capture all the relevant factors affecting corporate bond returns. Further research could explore the inclusion of additional factors or refine the model to improve its explanatory power.

“The model’s findings contribute to ongoing discussions in the field of finance and investment by providing insights into the relationship between consumption risk and corporate bond risk premiums,” Professor Jo adds. “These findings can inspire further research and the development of more comprehensive models to deepen our understanding of bond markets and enhance investment strategies.”