Corporate bond payoffs are intrinsically non-linear, making it difficult for traditional factor models to explain the cross-section of bond returns. We combine a reduced-form affine term structure model with mean-variance portfolio allocation to propose a default-adjusted CAPM.

Our framework introduces credit betas: a bond-specific measure of default risk easily derivable from bond analytics that maps directly to each bond’s loading on priced systematic default risk. This approach allows us to perform risk adjustments without estimating bond-specific default probabilities, a notoriously difficult task. The adjustment implies that cross-sectional returns increase with credit betas and decrease with duration. Using US corporate bond data, we construct a strategy that shorts duration while going long credit beta, delivering a marketorthogonal Sharpe ratio of 1.1, roughly 2.5 times the duration-hedged market return.