Beating the Benchmark: Bond Portfolios based on Country and Industry Factors

In this paper, we propose a dynamic portfolio strategy for European corporate bonds based on a two-factor pricing model: country and industry. We introduce a strategy in which we forecast both future factors as well as bonds' future exposure to these factors. Using a unique dataset that is representative of the universe of actively quoted European corporate bonds, we find that the strategy outperforms the naive benchmark. Our strategy yields a Sharpe ratio of 0.15 in the optimal setting, relative to the naive portfolio of 0.07. The results are mainly driven by the forecasted factors and less by forecasted exposures to these factors. The performance is especially driven by the euro-countries and suggests that `tides' of bond market integration are an important contributor to performance. Finally, our findings suggest that the strategy benefits from a more heterogeneous cross-section of countries.