Decomposing the Returns on European Corporate Debt

Common variation in the prices of defaultable securities may not always be associated with a rational response to an increase in the relative importance of a macroeconomic risk factor. Building on Campbell's ICAPM framework, we show that risk premia of assets with nonlognormal return distributions represent compensation not only for exposure to macroeconomic factors but also for unexpected revisions to these assets' return distributions, such as sudden increases in the likelihood of extreme events. If these revisions are made almost simultaneously across assets - perhaps as a systemic response to adverse credit-market events - they induce covariation in risk premia unrelated to the time variation of priced macroeconomic factors. Evidence from the European corporate bond market supports this theory. Asset pricing tests also document patterns consistent with the quot;flight-to-quality'' effect for European corporate debt