Downside risk and defaultable bond returns

Abstract

This paper analyzes the influence of downside risk on defaultable bond returns. By introducing a defaultable bond-trading model, we show that the decline in market risk tolerance and information accuracy leads to trading loss under downside conditions. Our empirical analysis indicates that downside risk can explain a large proportion of the variation in yield spreads and contains almost all valid information on liquidity risk. As the credit level decreases, the explanatory power of downside risk increases significantly. We also investigate the predictive power of downside risk in cross-sectional defaultable bond excess returns using a portfolio-level analysis and Fama-MacBeth regressions. We find that downside risk is a strong and robust predictor for future bond returns. In addition, due to the higher proportion of abnormal transactions in the Chinese bond market, downside risk proxy semi-variance can better explain yield spreads and predict portfolio excess returns than the proxy value at risk.

Keywords

• Downside risk
• Defaultable bond
• Trading model
• Yield spread
• Excess return