Corporate Stock and Bond Return Correlations and Dynamic Adjustments of Capital Structure

Abstract

This paper analyses the effects of dynamic correlations between stock and bond returns issued by the same firm on the speed of adjustment towards target leverage. The results show that the estimated correlations are time varying, show persistence, and differ among firms. Analysis of the potential explanatory variables reveals that the correlations decrease with negative expectations about future aggregate risks, but only for firms with a low default probability. In contrast, correlations are positively associated with specific risk measures, especially idiosyncratic stock risk and financial leverage. The positive relation between the correlations and the leverage ratio suggests that target leverage can be achieved faster when the stock-bond correlation is high. Our results show that this is the case.JEL Classification: G32, G12, G14

Stock and Bond Return Comovement as a Different Way to Assess Information Content: The Case of Debt Covenant Violation Disclosures

“…We document that the mean stock return for our sample drops by 5.78% in the short window around firms’ 8‐K disclosure of a DCV following a debt renegotiation, whereas the mean bond return drops by 0.57% (57 basis points) for firms with a DCV 8‐K violation disclosure over the same interval (details in the section on findings). This is consistent with the theory that the common risk factors facing stocks and bonds generate positive return comovement on average (Campbell and Ammer, 1993; Merton, 1974; Nieto and Rodriguez, 2015). Bondholders’ and shareholders’ responses to a DCV, however, may differ depending on whether the renegotiation waives or does not waive the DCV (i.e., how the renegotiation resolves the agency conflict).…”

Investor sentiment, flight-to-quality, and corporate bond comovement

“…Thus, it is not surprising that correlations are widely studied in the financial literature (e.g., Ang and Chen, 2002;Connolly et al, 2007;Baele et al, 2010;Abad et al, 2014;Nieto and Rodriguez, 2015). This evidence is based on correlations between equity markets, government bond markets, individual stocks and bonds, and common factors in asset prices and returns.…”

“…Studies that span asset classes such as sovereign bond and equity markets (e.g., Connolly et al, 2005;Yang et al, 2009;Baele et al, 2010;Baker and Wurgler, 2012;and Bansal et al, 2014) or sovereign bond, corporate bond and equity markets at the aggregate level (e.g., Baur and Lucey, 2009;Brière et al, 2012) document the evolution of financial integration and flight to low-risk sovereign bonds in market downturns. At the individual security level, Acharya et al (2013) find higher inter-market correlation between distressed stocks and corporate bonds in times of market downturns; Nieto and Rodriguez (2015) document common factors driving correlation between US stocks and corporate bonds of the same issuer. Correlations within asset classes are assessed either directly (e.g., Steeley, 2006 for different maturity segments of the UK sovereign bond market) or via common risk factors (e.g., Steeley, 1990;Litterman and Scheinkman, 1991 for UK and US sovereign bonds; Fama and French, 1993;Collin-Dufresne et al, 2001;Elton et al, 2001;Gebhardt et al, 2005;and Lin et al, 2011 for US corporate bonds; Klein andStellner, 2014 andAussenegg et al, 2015 for European corporate bonds).…”

Stock‐bond return co‐movement and accounting information

“…In line with that, Bhanot, Mansi, and Wald () find that takeover risk explains cross‐sectional variation in the correlation between stock and bond returns. Finally, Nieto and Rodriguez () show that co‐movement has important implications for capital structure choices.…”