The Determinants of Stock and Bond Return Comovements

Abstract

We study the economic sources of stock-bond return comovements and its time variation using a dynamic factor model. We identify the economic factors employing a semi-structural regime-switching model for state variables such as interest rates, inflation, the output gap, and cash flow growth. We also view risk aversion, uncertainty about inflation and output, and liquidity proxies as additional potential factors. We find that macroeconomic fundamentals contribute little to explaining stock and bond return correlations, but that other factors, especially liquidity proxies, play a more important role. The macro factors are still important in fitting bond return volatility; whereas the "variance premium" is critical in explaining stock return volatility. However, the factor model primarily fails in fitting covariances.

Macro-Finance Determinants of the Long-Run Stock-Bond Correlation: The DCC-MIDAS Specification

“…Agnew and Balduzzi (2006) find that investors rebalance portfolios as responses to changes in asset prices, and that this results in a negative correlation between transfers in stocks and bonds, which in turn leads to a negative correlation between returns in these two markets. Baele et al (2010) show that liquidity related variables hold predictive power for the stock-bond comovement, whereas macroeconomic variables hardly do. In general, stock and bond comovement is expected to be positive except in periods of "flight-to-quality".…”

“…Crisis periods may drive investors and traders from less liquid stocks into highly liquid bonds, and the resulting price-pressure effects may include negative stock-bond correlations. Therefore, as in Baele et al (2010), we include the trading volume of S&P500 future contracts as the liquidity-related variable in the paper. Ilmanen (2003), Guidolin and Timmermann (2006), and Aslanidis and Christiansen (2013) show that the general state of the macro economy provides information about the future stock-bond correlation.…”

“…They examine the long-run volatility component using economic factors. Baele et al (2010) and Colacito et al (2011) apply the MIDAS technique to the DCC model of Engle (2002) to decompose the comovement of stocks and bonds into short-run and long-run components. Finally extend the DCC-MIDAS model by allowing macro-finance variables to enter the long-run component of the correlation of crude oil and stock returns.…”

Identifying safe haven assets for equity investors through an analysis of the stability of shock transmission

“…Kim et al, 2006 also find obvious downward trends in time-varying correlations between stock and bond market returns in Europe, Japan and the US. More recently, however Baele et al, 2010 find that this 'trend' has not persisted and that the stock-bond return correlation displays much time variation.…”

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.…”