The Key Drivers of Corporate Bond Returns

Corporate bonds are an important asset class for investors, with the total U.S. corporate bond market comprising more than $10 trillion in outstanding debt. Guido Baltussen, Frederik Muskens, and Patrick Verwijmeren, authors of the May 2025 study "The Cross-Section of Corporate Bond Returns" conducted a comprehensive analysis of the U.S. corporate bond market, focusing on understanding why some corporate bonds outperform others. They examined the cross-section of U.S. corporate bonds and accounted for the infrequent trading of corporate bonds, sample selection bias, duration-matching, and high frequency data issues to provide a more accurate picture of what determines corporate bond returns. (Prior research had found that corporate bond returns could be decomposed into two key components: duration [interest rate risk] and credit spread [credit risk.]) Their data set is from the Bloomberg U.S. Aggregate Corporate Index and the Bloomberg U.S. High Yield Index in which prices are based on a combination of transaction data and broker and dealer quotes and covers the period January 1994 until June 2022.

Their research addressed several methodological challenges that have historically complicated corporate bond analysis:

Infrequent Trading: Unlike stocks, corporate bonds don't trade daily, making it difficult to assess true performance patterns. The authors developed methods to account for this irregularity.

Sample Selection Bias: Previous studies may have inadvertently focused on more liquid or popular bonds, potentially skewing results. The researchers worked to create a more representative sample.

Duration-Matching: Since bonds have different maturity dates and interest rate sensitivities, proper comparison requires sophisticated duration matching techniques.

Their study builds upon previous research which has identified several important factors that influence corporate bond performance:

Credit Risk Factors: Traditional models have focused heavily on credit ratings and default probabilities as primary drivers of bond returns.

Liquidity Considerations: The corporate bond market is less liquid than equity markets, and liquidity premiums can significantly impact returns.

The following is a summary of their key findings:

Market Risk Factors:

· Out of a set of 19 factors examined, net-of-costs, four factors offered unique, robust, and sizable return premia—a short maturity factor, a bond value factor, an equity momentum factor, and an accruals factor.

· A five-factor model that combines the credit market factor with these four factors most robustly prices the cross-section of corporate bonds after accounting for transaction costs.

· For investment grade corporate bonds, the return variation is at least 70% driven by Treasury returns, with even higher percentages for longer-dated bonds. For lower credit ratings, the variance explained by Treasury returns declines monotonically but remains substantial, especially for longer maturities. The lower the credit risk, the more the corporate bond excess return are driven by changes in the government bond yield curve.

· Returns increased monotonically with option-adjusted spreads, credit relative value, past one-month bond returns, and equity momentum, whereas they declined monotonically with issuer bond size, investments (change in assets) and working capital accruals.

· The credit return volatility increased monotonically with rating, option-adjusted spreads, credit relative value, and equity book-to-market, and decreased monotonically with issuer bond size and issuer equity size.

· Bonds with longer time-to-maturity and worse equity momentum were more volatile, but this effect was not strictly monotonic.

· Bonds with long maturities earned abnormally lower credit returns than bonds with short maturities—long maturity bonds are in high demand, which lowers their expected returns.

When comparing the performance of their factor model to alternative models found in the literature, the authors concluded: “Our five-factor model significantly outperforms the competing models across model selection criteria. Further, we show that these findings are robust across sample and testing choices, such as separating the sample by investment grade or high yield bonds or by including factors with less coverage due to historical data requirements. Overall, our analysis suggests that our factor model provides a useful addition to existing models.”

Key Takeaways for Investors

Duration-Adjusted Analysis is Critical: The emphasis on duration-matching reinforces that investors cannot simply compare bonds without accounting for their different interest rate sensitivities. A proper analysis requires sophisticated risk-adjustment techniques.

Data Quality Impacts Results: The authors' focus on addressing data limitations suggests that investors should be cautious about analyses based on incomplete or biased datasets, particularly in the corporate bond market where data quality can vary significantly.

Enhanced Risk Assessment: Understanding the true drivers of corporate bond returns can help investors build more accurate risk models and improve portfolio optimization.

Improved Security Selection: By identifying the factors that truly drive cross-sectional return differences, investors can make more informed decisions about individual bond selection.

Summary

The work by Baltussen, Muskens, and Verwijmeren represents an important contribution to our understanding of corporate bond returns. By addressing key methodological challenges and focusing on cross-sectional analysis, their research provides a more rigorous foundation for understanding what drives performance differences in the corporate bond market.

For investors, the key lesson is that successful corporate bond investing requires sophisticated analytical approaches that account for the unique characteristics of bond markets, including infrequent trading, varying liquidity, and complex risk factors.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies.