A Credit Risk Explanation of the Correlation between Corporate Bonds and Stocks *
79 Pages Posted: 6 Jul 2022 Last revised: 17 Oct 2023
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
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