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

48 Pages Posted: 29 Jul 2010

See all articles by Ilhan Demiralp

Ilhan Demiralp

University of Oklahoma - Division of Finance

Scott E. Hein

Texas Tech University - Area of Finance

Date Written: July 29, 2010

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

Suggested Citation

Demiralp, Ilhan and Hein, Scott E., Debt Default Risk and the Correlation of Stock Returns and Bond Yield Changes (July 29, 2010). Available at SSRN: https://ssrn.com/abstract=1650739 or http://dx.doi.org/10.2139/ssrn.1650739

Ilhan Demiralp

University of Oklahoma - Division of Finance ( email )

Norman, OK 73019
United States

Scott E. Hein (Contact Author)

Texas Tech University - Area of Finance ( email )

PO Box 42101
Lubbock, TX TX 79409
United States
806-8342-3433 (Phone)
806-742-2099 (Fax)

HOME PAGE: http://www.depts.ttu.edu/rawlsbusiness/people/faculty/finance/scott-e-hein/index.php

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