Comovement of Corporate Bonds and Equities

Fisher College of Business Working Paper No. 2013-03-11

Charles A. Dice Center Working Paper No. 2013-11

45 Pages Posted: 12 Jul 2013  

Jack Bao

Board of Governors of the Federal Reserve System

Kewei Hou

Ohio State University (OSU) - Department of Finance

Date Written: July 7, 2013

Abstract

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.

Keywords: Comovement, Hedge ratios, Structural models of default, Ratings

JEL Classification: G12, G13, G14

Suggested Citation

Bao, Jack and Hou, Kewei, Comovement of Corporate Bonds and Equities (July 7, 2013). Charles A. Dice Center Working Paper No. 2013-11. Available at SSRN: https://ssrn.com/abstract=2293027 or http://dx.doi.org/10.2139/ssrn.2293027

Jack Bao (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Kewei Hou

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-0552 (Phone)
614-292-2418 (Fax)

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