PhD Defence: Frederik Muskens

Abstract

This thesis investigates the differences in risk and return of corporate bonds and how investor behavior and market frictions influence corporate bond prices. In contrast to what economic theory predicts, empirical data shows that high- and low-risk corporate bonds deliver unexpectedly similar returns. This seems to be driven by corporate bond investors that are very focused on maximizing their expected return and thereby are willing to accept high risks. This risk-seeking behavior increases prices of high-risk investments and lowers their future return, and tends to intensify when overall expected returns are low and risks are perceived to be low.
If risk only partially explains the difference in returns, what else can explain it? It turns out that four specific characteristics help to distinguish bonds with low returns from bonds with high returns. Bonds close to their maturity date, undervalued bonds, bonds of firms with high stock returns, and bonds of firms that truly received their revenues (instead of only accounted for them), tend to earn higher risk-adjusted returns. To earn these higher risk-adjusted returns, however, investors continuously need to buy the most attractive bonds and sell bonds with worsened characteristics. Actively trading these corporate bonds is expensive. Accounting for transaction costs lowers the expected returns, but we still do not fully understand why the differences in returns remain so large and why smart investors can profit from them.