Understanding the Comovement between Corporate Bonds and Stocks: The Role of Default Risk

Abstract

We show that firm default risk is the primary predictor of the comovement between corporate bond and stock returns, both in the cross-section and over time. Intuitively, bonds of less creditworthy firms behave more like the issuing firms’ stocks, resulting in higher future comovement. We find that investing in bonds and stocks of the most creditworthy firms significantly enhances diversification benefits and Sharpe ratios out-of-sample. We develop a structural model with stochastic asset variance that rationalizes these findings. The model is consistent with salient asset pricing and default risk moments and contributes to understanding the forces driving stock-bond comovement.

Keywords: Corporate bonds, stock-bond comovement, default risk, structural model, asset pricing

JEL Classification: G12, G13