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This article investigates for the first time the role of idiosyncratic tail risk in the cross-sectional pricing of bond returns. We use the idiosyncratic return of the bond to measure the idiosyncratic tail risk based on the extreme value theory. The results show that bonds in the highest idiosyncratic tail risk quintile generate 3.5% more annual return compared to bonds in the lowest idiosyncratic tail risk quintile. In addition, we found that idiosyncratic tail risk is cross-sectionally positive correlated with bond expected returns in Chinese bond market, even when the downside risk, bond rating, liquidity, size, maturity, bond market beta, short-term reversals, and coupon rate are controlled. The positive correlation is in line with the traditional risk-return tradeoff theory. Because of their aversion to extreme losses, investors are willing to accept the low returns from low idiosyncratic tail risk bonds.

Is idiosyncratic tail risk priced in the cross-section of bond returns? –Evidence from Chinese bond markets