Downside Variance Premium, Firm Fundamentals, and Expected Corporate Bond Returns

Abstract

We find a strong and robust positive relationship between individual downside variance premia (DVP)--the difference between risk-neutral and physical expected downside variances--and future corporate bond returns. The spread portfolio that longs the high DVP bond portfolio and shorts the low DVP bond portfolio earns a statistically significant excess return of 0.37% (0.42%) per month in value- (equal-)weighted returns. The alpha estimates from various factor models remain statistically significant and economically substantial. The predictive power of the downside variance premium is stronger in noninvestment-grade (long-maturity) corporate bonds than in investment-grade (short-maturity) bonds. We show that the downside variance premium positively relates to the likelihood of future default and cash flow uncertainty and negatively relates to future cash flows.

Keywords: Downside variance Premium, Corporate Bond Return Predictability, Equity Options, Probability of Default, Credit Rating Downgrade, Cash Flow Uncertainty

JEL Classification: G10, G12, G14