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

84 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

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

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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