Why credit risk is something to bear in mind
The asymmetric distribution of corporate bond returns is easily explained by the Merton model introduced earlier. Numerous studies substantiate that even the return distributions of less risky and more liquid asset classes like government bonds are skewed and leptokurtic. Moreover, index returns exhibit significant autocorrelation that can be explained partially by a permanent component. Basically, bond returns are a result of price movements, interest accrual, pull to par, and roll down of the yieldcurve effects. While the first component is highly variable the other three
components are rather stable over time.
Because of their long history and good data reliability the empirical study is based on Merrill Lynch indices for the period January 1987 to September 2003. So the sample period comprises 201 months, spanning more than two business cycles. It contains the 1989/90 US recession, two periods of dramatic Fed tightening, the Tequila crisis in 1994, the Asian crisis in 1997, and Russia’s default in 1998. Driven by a secular trend of disinflation the yield of 10-year treasury notes declined from 7.2 to 3.9 percent in this period. With regard to future return expectations this should be kept in mind.