Debt Default Risk and the Correlation of Stock Returns and Bond Yield Changes

Abstract

Using Merton’s (1974) structural model corporate debt default, this paper argues that correlation between firm level corporate bond yield changes and stock returns should be informative about firm level default risk of this corporate debt. In particular, as the absolute value of the correlation increases, Merton’s framework suggests that default risk increases. We estimate the contemporaneous correlation between firm level corporate bond yield changes and stock returns using daily data, and investigate how this variable sheds light on firm level default risk, as measured by distance to default. We find evidence that as the stock-bond correlations increase in absolute value, the default risks of bonds increase, as expected. In addition, we examine if changes in the stock-bond correlation and the probability of future credit rating changes are related. We find that as the stock-bond correlation increases in absolute value, the probability of credit rating downgrades increases, which is consistent with the finding that the stock-bond correlation is a proxy for default risk.

Keywords: debt default risk, firm level correlation across debt and equity markets, distance to default, credit ratings

JEL Classification: G0, G1, G12, G24, G32