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

• Author: Ranko Jelic,Lukas Goetz,Wolfgang Aussenegg
• Published date: 01 March 2015
• Date: 01 March 2015
• DOI: http://doi.org/10.1111/j.1468-036X.2013.12009.x

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,

A‐1040Vienna, Austria

E-mail: waussen@pop.tuwien.ac.at

Lukas Goetz

UNIQA Capital Markets GmbH, Untere Donaustraße 21, A‐1029, Vienna, Austria

E-mail: lukas.goetz@uniqa.at

Ranko Jelic

Department of Accounting and Finance, University of Birmingham, Birmingham, B15 2TT, UK

E-mail: r.jelic@bham.ac.uk

Abstract

We examine monthly excess returns for 23 Euro‐denominated corporate bond

indices and propose a new specification for bond asset pricing models. Specifically,

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, significantly

improve the explanatory power of the Fama and French (1993) 2‐factor model.

We also demonstrate different sensitivities of risk factors before and after recent

financial crisis. The results are robust to calendar seasonality and the

consideration of equity market returns.

Keywords: asset pricing, Euro corporate bonds, factor models, financial 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, 265–308

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 financial system has experienced

an unprecedented transformation, most notably impacting the corporatebond market. The

monetary unification 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 finance 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

flows 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.

1

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.

2

Castegnetti and Rossi (2011) report that only one unobserved common factor has a

significant 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 first study to analyse the performance of a wide range of

duration and rating‐grouped Euro‐denominated 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 five

years. We contribute to the literature in the following ways: firstly, we extend the Fama

and French (1993) 2‐factor 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

1

For comparison, the US ratio was hovering between 20–30% throughout 2000s. Calculations

made by authors, based on figures for corporate bond issues by non financial institutions from

BIS (2011).

2

Castagnetti and Rossi (2011) examine 207 bonds during the 2002‐2004 period. Klein and

Stellner (2012) examine 784 bonds from Germany, France, Italy, the Netherlands, and Spain

during the period 1999‐2010.

© 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 financial crisis and shed more light on changes in the importance of various factors,

including market liquidity.

Our main findings 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) 2‐factor model; (ii) Common risk factors of the 2‐factor and

our 4‐factor model are, however, not able to price bonds with short maturities well enough,

essentially underestimating their performance and leaving a significant portion of the cross‐

sectional return variation unexplained; (iii) Our liquidity augmented 4‐factor model depicts a

significant liquidity premium for short term bonds, after the start of the financial crisis in

2007; (iv) We demonstrate different sensitivities (and statistical significance) of risk factors

before and after recent financial crisis; (v) In line with previous studies we do not find

evidence that lower‐rated bonds (A and BBB) compensate investors with significantly higher

returns compared to debt securities with superior credit rating.

The remainder of this paper proceeds as follows: Section 2 briefly 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 2‐factor model for bond returns, incorporating one term

and one default factor. They also report that lower rated corporate bonds do not compensate

investors with significantly higher returns in relation to bonds of superior credit quality.

Following Fama and French, several improvements to the 2‐factor model have been

proposed. For example, Elton et al. (1995) test a model that incorporates a premium

associated with unexpected inflation changes and economic growth. However, the

explanatory power is only marginally improved compared to the original Fama and French

specification. Elton et al. (2001) suggest that systematic risk factors associated with expected

returns on equity are of primary importance for bond returns. Collin‐Dufresne 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 market‐wide 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 cross‐sectional 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 first testable hypothesis:

Hypothesis 1: Only a few risk factors are sufficient to explain the common movement of

European corporate bond returns.

Duffee (1998) reports the importance of a term factor of the interest rate curve, defined

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