"Comovement of Corporate Bonds and Equities" Authors: Jack Bao (Federal Reserve Board of Governors) and Kewei Hou (Ohio State Univ.)

Abstract We study heterogeneity in the comovement of corporate bonds and equities, both at the bond level and at the rm level. To formalize empirical predictions, we use an extended Merton model to illustrate that, holding the actual maturity constant, corporate bonds that are due late relative to the rest of the bonds in their issuers’ maturity structure should have stronger comovement with equities. In contrast, an endogenous default model with equity pay-in suggests that a bond’s position in its issuer’s maturity structure has little relation with the strength of the comovement. In the data, we nd that bonds that are later in their issuers’ maturity structure comove more strongly with equities, consistent with the prediction of the extended Merton model. In addition, we nd that the comovement between bonds and equities is stronger for rms with higher credit risk as proxied by higher book-to-market ratios and lower distance-to-default even after controlling for ratings. Our results highlight the important eects of bond and rm level characteristics on the relative returns of corporate bonds and equities.