Understanding the Correlation between Corporate Bonds and Stocks: The Role of Asset Variance

Abstract

We show that firm default risk is the primary predictor of the correlation between corporate bond and stock returns, both in the cross-section and over time. Bonds of less creditworthy firms behave more like the issuing firms’ stocks, resulting in higher future comovement. As a direct implication, 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, whereby time variation in asset variance plays a critical role in breaking down the perfect stock-bond correlation implied by the Merton model.