On the Fundamental Relation between Equity Returns and Interest Rates

Abstract

This paper uses contingent claim asset pricing and exploits capital structure priority to better understand the relation between corporate security returns and interest rate changes (i.e., duration). We show theoretically and, using a novel dataset, confirm empirically that lower priority securities in the capital structure, such as subordinated or distressed debt and equity, have low or even negative durations because these securities are effectively short higher priority, high duration fixed rate debt. This finding has important implications for interpreting existing results on (i) the time-varying correlation between the aggregate stock market and government bonds, (ii) the use of bond factors for multifactor asset pricing models and forecasting bond and stock returns, (iii) the Fisher effect and inflation, and (iv) the betas of corporate bonds.