Joseph Cheng, Joshua Cheng

(School of Business, Ithaca College, USA)

 

 

Abstract: While growth is universally recognized as an important factor for determining stock return, it is rarely considered a relevant factor for determining bond returns. This paper sheds light on the relationship between two important risk factors: growth and default risk. While it is well known that corporate bond returns and stock returns are correlated, the precise nature of such correlation is unclear because the total return is a composite of various unobservable factors. We hypothesize that a significant portion of the observed correlation between bond and stock returns originates from the unseen correlation between growth and default risk. There has not been extensive work done in analyzing such correlation, which is likely due to the problem of identifying the unobservable growth and default risk factors. In this paper, we extract the default factor return (portion of return due to change in default risk) from total bond returns. We also extract the growth factor return from the S&P return. It is found that growth return has a stronger correlation with the default factor return for junk bond portfolio than with the default factor return for investment grade bond portfolio. This explains the literature findings that junk bonds are more strongly correlated with stocks than investment grade bonds.

 

 

Key words: bond; stock; growth; default risk

 

JEL codes: G11, G12