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A common risk factor and the correlation between equity and corporate bond returns

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  • Demirovic, Amer
  • Kabiri, Ali
  • Tuckett, David
  • Nyman, Rickard

Abstract

A growing body of literature documents that security prices within and across asset classes behave similarly highlighting the importance of investors’ common expectations about future risk and returns in the asset pricing. Consequently, variations in the common expectations of investors have a major role in determining the correlation among asset prices. We examine the role of these common expectations in determining the relationship between firm-level equity and bond returns. We use a novel measure of the common expectations defined as the difference in relative frequencies of words signalling excitement and anxiety in a large dataset of articles published by Reuters. Further, we also consider the VIX index and the indices of Baker and Wurgler (J Finance 61(4):1645–1680, 2006) and Huang et al. (Rev Financ Stud 28(3):791–837, 2015) as potential common factors. The results show that changes in common expectations, proxied by our index and the VIX, are significant in predicting variations in the correlation between equity and bond returns. An improvement in investors’ optimism about future risk and returns causes a weaker correlation. The effect is stronger for the riskiest firms and flattens as firms’ credit risk improves. By decomposing our index into the excitement and anxiety components, we find that this predictive power is due to changes in the anxiety components.

Suggested Citation

  • Demirovic, Amer & Kabiri, Ali & Tuckett, David & Nyman, Rickard, 2020. "A common risk factor and the correlation between equity and corporate bond returns," LSE Research Online Documents on Economics 116902, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:116902
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    File URL: http://eprints.lse.ac.uk/116902/
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    More about this item

    Keywords

    credit risk; equity–bond correlation; investor sentiment; systematic risk;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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