Common Risk Factors in the Returns on Stocks and Bonds

Five common risk factors in the returns on stocks and bonds are identified. There are 3 stock market factors: an overall market factor and the factors related to firm size and book-to-market equity. There are 2 bond market factors, related to maturity and default risks. Stock returns have shared variation due to the stock market factors, and they are linked to bond returns through shared variation in the bond market factors. Except for low-grade corporates, the bond market factors capture the common variation in bond returns. Most importantly, the 5 factors seem to explain average returns on stocks and bonds. In principle, the results can be used in any application that requires estimates of expected stock returns. The applications depend on the evidence that the 5 factors provide a good description of the cross-section of average returns, but they do not require that the true factors have been identified.