In Search of Systematic Risk and Idiosyncratic Volatility Puzzle in the Corporate Bond Market

Abstract

We propose a comprehensive measure of systematic risk for corporate bonds as a non-linear function of robust risk factors and find a significantly positive link between sys-tematic risk and the cross-section of future bond returns. We also provide evidence of a positive but insignificant relation between idiosyncratic risk and future bond returns, suggesting that institutional investors that dominate the corporate bond market hold well-diversified portfolios with a negligible exposure to bond-specific risk. When replicating the analysis for the equity market, we find a significantly negative link between idiosyncratic volatility and future stock returns, whereas systematic variance does not command a significant risk premium. The puzzling idiosyncratic volatility effect is stronger for stocks held by retail investors, whereas the systematic risk premium is stronger for corporate bonds held by active institutional investors. Thus, our results provide an explanation for the significance of systematic risk (idiosyncratic risk) based on differing investor preferences and clienteles in the bond (equity) market.