Factors related to carry, duration, equity momentum, and the term structure are the most important risk factors in corporate bond markets. From a large set of factor candidates, we condense an optimal model with a two-step approach. First, we filter out factors that do not systematically move bond prices. Second, we use a Bayesian model selection approach to determine the optimal, parsimonious model. Many prominent factors do not move prices or are redundant. We document the new model’s good performance compared to that of existing models in time-series and cross-sectional tests and analyze the economic drivers of the factors.

Which factor model do investors in corporate bonds use? We examine this question by tracking investors’ decisions to invest in actively managed corporate bond mutual funds with a revealed preference approach. Our main result is that all bond factor models are dominated by the simple Sharpe ratio and Morningstar ratings. For all major corporate bond mutual fund styles, the Sharpe ratio explains fund flows better than alphas from bond factor models. Since the Sharpe ratio (and to some extent also Morningstar ratings) can be easily manipulated in bond markets, our findings have potentially severe implications for all market participants.