Comovement of Corporate Bonds and Equities
Board of Governors of the Federal Reserve System
Ohio State University (OSU) - Department of Finance
July 7, 2013
Fisher College of Business Working Paper No. 2013-03-11
Charles A. Dice Center Working Paper No. 2013-11
We study heterogeneity in the comovement of corporate bonds and equities, both at the bond level and at the firm level. Using an extended Merton model, we illustrate that corporate bonds that mature late relative to the rest of the bonds in its issuer's maturity structure should have stronger comovement with equities. In contrast, endogenous default models suggest that a bond's position in its issuer's maturity structure has little relation with the strength of the comovement between bonds and equities. Empirically, we find results consistent with the prediction of the extended Merton model. In addition, we find that comovement between bonds and equities is stronger for firms with higher credit risk as proxied by the book-to-market ratio and distance-to-default even after controlling for ratings. Our evidence suggests that market participants are able to assess credit quality at a more granular level than ratings.
Number of Pages in PDF File: 45
Keywords: Comovement, Hedge ratios, Structural models of default, Ratings
JEL Classification: G12, G13, G14
Date posted: July 12, 2013
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