A Credit Risk Explanation of the Correlation between Corporate Bonds and Stocks *

79 Pages Posted: 6 Jul 2022 Last revised: 17 Oct 2023

See all articles by Alexander Dickerson

Alexander Dickerson

UNSW Business School

Mathieu Fournier

UNSW Business School

Alexandre Jeanneret

UNSW Business School

Philippe Mueller

Warwick Business School Finance Group

Date Written: October 12, 2023

Abstract

Default risk positively predicts the correlation between corporate bond and stock returns, dominating alternative explanations such as liquidity. We show that a strategy investing in stocks and bonds of low-default-risk firms, betting on low future correlation, generates a high Sharpe ratio due to superior diversification benefits. We rationalize these findings with a credit risk model that incorporates stochastic asset variance and interest rates. This model not only matches key equity and credit moments but also generates new predictions about the stock-bond correlation and the joint factor structure in both markets. An extensive empirical analysis supports our model implications.

Keywords: JEL Classification Numbers: G12, G13 Stock-bond correlation, default risk, interest rate risk, variance risk, structural credit models

JEL Classification: G12, G13

Suggested Citation

Dickerson, Alexander and Fournier, Mathieu and Jeanneret, Alexandre and Mueller, Philippe, A Credit Risk Explanation of the Correlation between Corporate Bonds and Stocks * (October 12, 2023). Available at SSRN: https://ssrn.com/abstract=4138544 or http://dx.doi.org/10.2139/ssrn.4138544

Alexander Dickerson (Contact Author)

UNSW Business School ( email )

UNSW Business School
High St
Sydney, NSW 2052
Australia

Mathieu Fournier

UNSW Business School ( email )

UNSW Business School
High St
Sydney, NSW 2052
Australia

Alexandre Jeanneret

UNSW Business School ( email )

Sydney, NSW 2052
Australia

Philippe Mueller

Warwick Business School Finance Group ( email )

Gibbet Hill Rd
Coventry, CV4 7AL
Great Britain

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