Prospect theory and corporate bond returns: An empirical study

Since the 1980s, prospect theory has been considered as the most successful descriptive theory for decision making. In this paper, we examine the predictive power of prospect theory in the U.S. corporate bond market. The empirical evidence shows that prospect theory has significant predictive power for corporate bond returns, especially for junk bond returns. Unlike the findings for the stock market, the loss aversion component plays the most important role in predicting corporate bond returns. The probability weighting component also plays a predictive role for junk bonds, but not for investment-grade bonds.