In this paper, we examine how the contemporaneous correlation between the daily corporate bond yield changes and the firms stock returns at the firm level (hereafter simply referred to as the stock-bond correlation) changes in relation to default risk, arguing that this stock-bond correlation provides useful information pertaining to the default risk of bonds for the firm. In particular, we show that the absolute value of the correlation between firm level bond yield changes and stock returns should be positively related to the default risk of the firm.
Using the distance to default measure developed in Merton (1974) and implemented in Vassalou and Xing (2004), we find that there is indeed a positive and a contemporaneous relationship between this measure of default risk and the absolute value of the stock-bond correlation. As this measure of default risk increases, the stock-bond correlation increases in absolute value. This suggests that an easily measured variable, stock-bond correlation of a firm, is a parsimonious measure of a firm?s default risk.
Empirical evidence shows that as the credit ratings of bonds deteriorate, bonds behave more like their issuing firms? stocks (Cornell and Green 1991; Kwan 1996). Kwan (1996), for example, shows that for low (high) grade bonds, the conditional correlation between the stock returns and the issuing firm?s bond yield changes is high (low), while the correlation between the stock returns and the risk-free interest rates is low (high).
He concludes, not surprisingly, that AAA-rated bonds “resemble” risk-free bonds more than they do risky bonds. He also finds evidence that low grade bonds “resemble” their issuing firms' stocks more than they do high grade bonds. We have occasionally heard commentators suggest a similar phenomenon by stating in street lingo that high-yield bonds resemble “equity in drag.”