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| Excess Volatility of Corporate Bonds by Jack Bao of the Massachusetts Institute of Technology, and February 28, 2008 Abstract: This paper examines the connection among corporate bonds, stocks, and Treasury bonds under the Merton model with stochastic interest rate, focusing in particular on the volatility of corporate bonds and its connection to the equity volatility of the same firm and the Treasury bond volatility. For a broad cross-section of corporate bonds from 2002 through 2006, empirical measures of bond volatility are constructed using bond returns over daily, weekly, and monthly horizons. Comparing the empirical volatility with its model-implied counterpart, we find an overwhelming degree of excess volatility that is difficult to be explained by a default-based model. This excess volatility is found to be the strongest at the daily and weekly horizons, indicating a more pronounced liquidity component in corporate bonds at short horizons. At the monthly horizon, the excess volatility tapers off but remains significant. Moreover, we find that variables known to be linked to bond liquidity are important in explaining the cross-sectional variations in excess volatility, providing further evidence of a liquidity problem in corporate bonds. Finally, subtracting the equity and Treasury exposures from corporate bond returns, we find a non-trivial systematic component in the bond residuals that give rise to the excess volatility. |
