Common Factors in the Performance of European Corporate Bonds – Evidence before and after the Financial Crisis

AuthorRanko Jelic,Lukas Goetz,Wolfgang Aussenegg
Publication Date01 March 2015
Date01 March 2015
Common Factors in the Performance
of European Corporate Bonds
Evidence before and after the
Financial Crisis*
Wolfgang Aussenegg
Institute of Management Sciences, Vienna University of Technology, Theresianumgasse 27,
A1040Vienna, Austria
Lukas Goetz
UNIQA Capital Markets GmbH, Untere Donaustraße 21, A1029, Vienna, Austria
Ranko Jelic
Department of Accounting and Finance, University of Birmingham, Birmingham, B15 2TT, UK
We examine monthly excess returns for 23 Eurodenominated corporate bond
indices and propose a new specication for bond asset pricing models. Specically,
we separate level and slope components of term and default risk factors and
examine liquidity risk. Our results suggest that level and slope risk factors, derived
from complete interest rate and default spread term structures, signicantly
improve the explanatory power of the Fama and French (1993) 2factor model.
We also demonstrate different sensitivities of risk factors before and after recent
nancial crisis. The results are robust to calendar seasonality and the
consideration of equity market returns.
Keywords: asset pricing, Euro corporate bonds, factor models, nancial crisis, anomalies
JEL classification: G12, G14, G15, G30
We would like to thank the editor (John Doukas) and two anonymous referees for their
helpful suggestions. We are grateful to Philip Kurmann, XiaoHua Chen, Bjarne Astrup
Jensen, Pedro Barroso, and participants at the 2012 European Financial Management
Association Symposium (Hamburg), the 2012 Portuguese Finance Network Conference
(Aveiro), and the 2012 Financial Engineering and Banking Society Conference (London)
for their comments. We also thank Thomson Reuters Austria GmbH for providing data.
Correspondence: Ranko Jelic.
European Financial Management, Vol. 21, No. 2, 2015, 265308
doi: 10.1111/j.1468-036X.2013.12009.x
© 2013 John Wiley & Sons Ltd
1. Introduction
In the wake of the complete liberalisation of capital transactions and the subsequent
introduction of a singlecommon currency, the European nancial system has experienced
an unprecedented transformation, most notably impacting the corporatebond market. The
monetary unication and elimination of foreign exchange risks createdan integrated pan
European bond marketthat has provided an important alternative to traditionalbank loans.
In the late 1990s, the deregulation of important sectors of the European economy (e.g.
telecommunications and energy) fueled enormous borrowing requirements by the
multinational groupsto nance investments and acquisitions. Atthe same time, bank loans
became more expensive due to the tighter regulation of European banks. On the demand
side, further integrationof European markets led to the abolishment of regulatoryobstacles
that had previously prohibited many institutional investors like pension funds and
insurance companies to direct their funds into foreign jurisdictions (Pagano and von
Thadden, 2004). More recently, the slump in the stock market and the development of
bond Exchange TradedFunds (ETFs) provided further impetus for the surge of investment
ows towards the corporate bond market.The above mentioned developments resulted in
the corporate bond market amounting to 18% of the total Euro zone GDP in early 2010,
compared to only 7% in 1999.
In spite of the phenomenal growth and importance of this
asset class, there is still a paucity of research on European corporate bonds.
Previous studies that examine samples consisting of individual European corporate
bonds report the existence of a liquidity premium (Houweling et al., 2005; Diaz and
Navarro, 2002; Frühwirth et al., 2010) and identify credit ratings as an important
determinant for the pricing of European corporate bonds (Gabbi and Sironi, 2005). The
results reported in recent studies echo the results reported in studies on US bonds. Klein
and Stellner (2012) and Castagnetti and Rossi (2011), for example, show that a stock
market factor has no explanatory power in the presence of default and term risk factors.
Castegnetti and Rossi (2011) report that only one unobserved common factor has a
signicant role in explaining systematic changes in credit spreads of European bonds.
According to the authors, this factor is not a market factor and is likely to be liquidity risk.
The objective of this study is to shed more light on the entire European market for
corporate bond indices by examining common risk factors governing their returns. To the
best of our knowledge, this is the rst study to analyse the performance of a wide range of
duration and ratinggrouped Eurodenominated corporate bond indices, including issues
with maturities of 1 to 3 years. Usually, these issues are either not available in databases or
blended in a broader maturity bracket, most often within a maturity range of one to ve
years. We contribute to the literature in the following ways: rstly, we extend the Fama
and French (1993) 2factor model by separating level and slope components of term and
default risk factors. The use of the Principal Component Analysis (PCA) allows us to
incorporate the dynamics of the complete interest rate and default spread term structures
For comparison, the US ratio was hovering between 2030% throughout 2000s. Calculations
made by authors, based on gures for corporate bond issues by non nancial institutions from
BIS (2011).
Castagnetti and Rossi (2011) examine 207 bonds during the 20022004 period. Klein and
Stellner (2012) examine 784 bonds from Germany, France, Italy, the Netherlands, and Spain
during the period 19992010.
© 2013 John Wiley & Sons Ltd
266 Wolfgang Aussenegg, Lukas Goetz and Ranko Jelic
(instead of an arbitrarily chosen maturity) and to apply a parsimonious and orthogonal
representation of the risk factors. Secondly, some recent studies highlighted the
importance of examining common factors (Acharya et al., 2010), default risk (Aretz and
Pope, 2011), and the predictability of bond returns (Thornton and Valente, 2012) during
periods of economic crisis. We, therefore, study the bond performance before and after the
recent nancial crisis and shed more light on changes in the importance of various factors,
including market liquidity.
Our main ndings can be summarised as follows: (i) Incorporating level and slope f actors
of the respective interest and default spread term structures improves the explanatory power
of the Fama and French (1993) 2factor model; (ii) Common risk factors of the 2factor and
our 4factor model are, however, not able to price bonds with short maturities well enough,
essentially underestimating their performance and leaving a signicant portion of the cross
sectional return variation unexplained; (iii) Our liquidity augmented 4factor model depicts a
signicant liquidity premium for short term bonds, after the start of the nancial crisis in
2007; (iv) We demonstrate different sensitivities (and statistical signicance) of risk factors
before and after recent nancial crisis; (v) In line with previous studies we do not nd
evidence that lowerrated bonds (A and BBB) compensate investors with signicantly higher
returns compared to debt securities with superior credit rating.
The remainder of this paper proceeds as follows: Section 2 briey reviews the relevant
literature and motivatesour hypotheses. Section 3 describes the main characteristicsof our
data and the sample selection.Section 4 deals with methodology. The resultsare presented
in section 5. Section 6 examinesthe robustness of our results. Finally, section7 concludes.
2. Literature and Hypotheses
Fama and French (1993) advocate a 2factor model for bond returns, incorporating one term
and one default factor. They also report that lower rated corporate bonds do not compensate
investors with signicantly higher returns in relation to bonds of superior credit quality.
Following Fama and French, several improvements to the 2factor model have been
proposed. For example, Elton et al. (1995) test a model that incorporates a premium
associated with unexpected ination changes and economic growth. However, the
explanatory power is only marginally improved compared to the original Fama and French
specication. Elton et al. (2001) suggest that systematic risk factors associated with expected
returns on equity are of primary importance for bond returns. CollinDufresne et al. (2001),
King and Khang (2005), and Gebhardt et al. (2005), however, report that aggregate equity
market risk has very limited explanatory power once bond related factors (i.e. default and
term risk) are controlled for. More recently, Acharya et al. (2010) and Lin et al. (2011) report
that marketwide liquidity risk is an important factor (in addition to Fama and French default
and term factors) in the pricing of US corporate bonds. Overall, the above evidence suggests
that a small set of carefully selected factors, incorporating term and default risk, are capable
of explaining the crosssectional performance of US corporate bond returns fairly well. We
anticipate that this proposition also holds in the more fragmented market for European
corporate bonds and, hence, specify our rst testable hypothesis:
Hypothesis 1: Only a few risk factors are sufcient to explain the common movement of
European corporate bond returns.
Duffee (1998) reports the importance of a term factor of the interest rate curve, dened
as the performance difference between a 30 year Treasury bond and the 3 month Libor
© 2013 John Wiley & Sons Ltd
Common Factors in the Performance of European Corporate Bonds 267

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