A Credit Risk Explanation of the Correlation between Corporate Bonds and Stocks
84 Pages Posted: 6 Jul 2022 Last revised: 17 Oct 2023
Date Written: October 12, 2023
Abstract
We develop a model to study the correlation between corporate bonds and stocks. The model predicts that a firm's stock and bond returns have opposite exposures to stochastic fluctuations in asset variance and interest rates, breaking the perfect stock-bond correlation implied by mainstream theories. Additionally, allowing for stochastic interest rates is pivotal in generating a positive link between stock-bond correlation and default risk. The model also has significant implications for asset allocation and predicts that the Sharpe ratio of portfolios combining stocks and bonds increases meaningfully with firms' creditworthiness. An extensive empirical analysis provides robust support for these novel predictions.
Keywords: Stock-bond correlation, default risk, interest rate risk, variance risk, structural models
JEL Classification: G12, G13
Suggested Citation: Suggested Citation