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Economic
Research & Data 
Publications
Economic Letter
FRBSF Economic Letter
96-20; July 5, 1996
The previous issue of the Economic Letter discussed the relationship
between the movements in the stock and bond market, at the macroeconomic
level. How stock and bond prices move relative to each other is important
because it directly affects the risk of a portfolio that contains both
kinds of long-term assets. While in theory, the correlation between changes
in stock and long-term bond prices can be either positive or negative,
depending on what underlying economic forces are driving asset prices,
the latest empirical evidence suggests that the correlation tends to be
positive, and although it seems small, it also appears to be increasing
over time.
This issue delves deeper into the relationship between stocks and bonds
by focusing at the individual firm level, or the microeconomic level.
While the previous analysis was based on virtually default-free Treasury
bonds, this analysis focuses on corporate bonds, which entail default
risk. Therefore, corporate bond prices are determined not only by the
interest rates in the economy but also by the credit risk borne by the
bondholders. The credit risk in a corporate bond depends on the expected
future cash flows of the issuing firm, which also determines the firm's
stock price; therefore, information about the firm's cash flow prospects
provides an important linkage between individual stocks and bonds that
is absent from the aggregate stock and default-free bond prices.
At issue is how this additional linkage affects the comovement between
individual stock and bond prices. In theory, information about a firm's
future cash flows can have either similar or dissimilar effects on its
stock and bond prices, implying that individual stock and bond prices
can be either positively or negatively correlated. This Economic Letter
reviews the theory as well as the latest empirical evidence on the
comovement between individual stock and bond prices based on recent U.S.
data. The comovement between stocks and bonds at the micro level is important
to an investor who holds both kinds of financial claims against the same
company because this correlation directly affects the risk of her portfolio.
It is also important to an investor who holds just the firm's bonds (stocks)
because the value of her bond (stock) holdings may be affected by the
value of the firm's stocks (bonds) that she does not hold. Finally, if
changes in individual stock price can be used to predict future changes
in individual bond price, or vice versa, the forecasting power of individual
asset price can lead to potentially profitable investment strategies.
This Letter investigates whether such profit potential exists
by examining the lead-lag relationship between individual stock and bond
prices.
Comovement between individual stocks and bonds
Stocks and bonds issued by the same firm represent different claims on
the same underlying assets of the firm. Hence, relevant information about
the firm should have an impact on both the firm's outstanding stocks and
its outstanding bonds, leading to comovement between individual stock
and bond prices. However, depending on the type of firm-specific information
disseminated over time, individual stocks and bonds can be either positively
or negatively correlated.
Suppose there is good news about the firm's future cash flows which leads
to an increase in the firm's market value. The firm's bonds should appreciate
in value because their default risk has declined. The firm's stocks also
should appreciate in value because they are claims on the firm's residual
cash flows, that is, the remaining cash flows after paying off the bondholders.
This should result in a positive correlation between the firm's stock
and bond prices.
On the other hand, suppose there is news that the firm has invested in
a risky project (relative to the firm's existing asset risk) that has
potentially high payoffs. Further suppose that on a risk-adjusted basis
the value of the firm is unchanged after the adoption of the risky project,
because the higher expected future cash flows are discounted at a higher
discount rate due to the increase in risk. Since bonds are fixed senior
claims, and since stocks are residual junior claims, the firm's cash flows
are not distributed symmetrically to its bondholders and stockholders.
The adoption of a risky project could lead to increase in the volatility
of the firm's cash flows, which would increase the default risk of the
firm's outstanding bonds, and, in turn depress their market value. On
the other hand, since the stockholders would get all the payoffs once
the bondholders are paid in full, the stockholders would reap all the
up-side gains of the risky project in the event that it succeeds in generating
superior payoffs. To put it in simpler terms, since the value of the firm
remains constant, and since it is claimed by both the bondholders and
the stockholders, a fall in bond value must be accompanied by a rise in
stock value, and vice versa. Hence, news about the underlying risk of
the firm would move the firm's outstanding stocks and bonds in opposite
directions, resulting in a negative correlation between individual stock
and bond prices.
Whether the prices of stocks and bonds issued by the same firm move in
the same or opposite directions, then, is an empirical question. Using
weekly data for U.S. firms, I find that individual stock and bond prices
tend to move in the same direction (see Kwan 1996 for full details). The
findings suggest that individual stocks and bonds are driven by firm-specific
information that is predominantly related to the mean value of the firm's
underlying assets rather than to the volatility of the firm's cash flows.
While the comovement between individual stocks and individual bonds was
detected regardless of firm size, this relationship was found to be absent
in the case of AAA-rated bonds. It appears that AAA-rated bonds may have
so little default risk relative to stocks that they are insensitive to
information about the issuing firm.
Lead-lag relationship between individual stocks
and bonds
After detecting the positive correlation between individual stock and
bond prices, the next question to explore is the dynamic of this correlation.
At issue is whether the stock market and the bond market are equally efficient.
In an efficient market, asset prices fully reflect all available information.
Hence, if firm-specific information reaches the stock market and the bond
market at the same time, as predicted by the efficient market hypothesis,
this information should be embedded into individual stock and bond prices
simultaneously, so that the price of one would not lead the price of the
other. However, if firm-specific information arrives at one market sooner
than the other market, this information would be embedded into individual
stock and bond prices at different times, resulting in a lead-lag relationship
between individual stocks and bonds.
Is it plausible that information will arrive at different markets at
different times? Firm-specific information can be classified as public
or private. Public information is known to all participants in both the
stock and the bond markets. As such, even in the absence of trading among
investors, public information would lead to price changes. Public information
most likely arrives at the stock and bond markets and is embedded into
individual stock and bond prices simultaneously.
Private information, however, is known only to the informed traders,
who seek to profit from their private information by trading with the
uninformed investors. These informed traders could systematically prefer
to trade in either the stock or the bond market, and, as a result, their
private information would be conveyed through one market or the other.
Their choice of market may depend on which has the lower transaction costs.
Since, in general, the transaction costs are lower for trading stocks
than trading bonds, informed traders may prefer to trade in the stock
market to take advantage of their private information. Furthermore, compared
to the bond market, the stock market tends to have higher liquidity and
hence is more resilient to trading activities. As a result, informed traders
may be better able to "hide" their trade in the stock market
than in the bond market. However, informed traders may prefer the bond
market because insider-trading laws require disclosure for stock, option,
and equity-linked bond transactions by insiders, while there is no disclosure
requirement for insider-trading activity in regular bonds, regardless
of bond rating. Hence, if the informed trader is an insider of the firm,
she may want to trade in the bond market to avoid disclosing her trading
activities. Therefore, a priori, it is not clear where the informed trader
would prefer to trade.
Furthermore, if an uninformed trader can spend resources to get information,
it is unclear whether investors in the stock market and the bond market
would make similar decisions about getting information. Stock investors
and bond investors may have different degrees of risk aversion, holding
periods, marginal tax brackets, and institutional constraints (for example,
commercial banks are prohibited from direct investing in equities), any
or all of which can lead to variations in the desire for information.
Based on the above considerations, it seems quite plausible that private,
firm-specific information may be reflected in individual stock and bond
prices at different rates.
If private information is first embedded in the stock (bond) price before
being reflected in the bond (stock) price, one would observe that individual
stocks lead (lag) individual bonds. In other words, individual bond (stock)
prices will comove with individual stock (bond) prices with a time lag.
Kwan (1996) found that past individual stock prices have explanatory power
for current individual bond prices. However, past bond prices have no
explanatory power for current stock prices. The findings indicate that
individual stocks tend to lead individual bonds, suggesting that firm-specific
information is embedded in the stock prices before being reflected in
the bond prices.
The lead-lag relationship between stocks and bonds was detected regardless
of firm size. This relationship holds for all except the AAA-rated bonds.
This further indicates that AAA-rated bonds are relatively insensitive
to firm-specific information. Along this line, while individual stocks
comove with individual bonds for all bonds rated below AAA, the strength
of the comovement was found to increase as the bond rating declines. This
suggests that firm-specific information embedded in stock prices plays
an increasingly important role in bond prices as the corporate bond becomes
riskier. Whereas AAA-rated bonds are relatively insensitive to firm-specific
information, the prices of bonds that are rated below investment grade
are heavily influenced by the issuing firm's stock prices and are insensitive
to changes in interest rates. Thus, speculative grade bonds appear to
behave more like equity securities than like fixed-income securities.
Individual stocks and bonds issued by the same firm are expected to move
together because they are claims on the same underlying assets. However,
the way that prices of stocks and bonds issued by the same firm move together
depends on the properties of firm-specific information disseminated over
time and on the dynamics of information flows in the stock and bond markets.
Recent research finds that individual stock and bond prices tend to move
in the same direction. This suggests that stocks and bonds are driven
by firm-specific information that is predominantly related to the mean
value, rather than the volatility, of the issuing firm's assets. In addition,
past individual stock prices are found to have forecasting power for current
individual bond prices, indicating that stocks lead bonds in reflecting
firm-specific information.
Simon Kwan
Economist
Kwan, Simon H. 1996. "Firm-Specific Information and the Correlation
between Individual Stocks and Bonds." Journal of Financial Economics
40, pp. 63-80.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
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