Correlation between debt and stock prices

Investors do not generally invest in individual assets they invest in a group of assets which is known as a portfolio. To gauge the performance of the portfolio it is important to determine the co-movement of different classes of assets.  This is done to mitigate and manage risk better. For example, if an asset portfolio consists of only stocks and gold the relationship between the price movements theoretically would be negative. Hence, risk can be hedged.

Under the risk and return framework, it should be noted that stocks are supposed to possess higher level of risk hence the return expected from the stocks in the long run is higher than the return expected from debts in the long run. The valuation of both stocks and debt are done with the help of cash flow models. These models are based on the premise that the value of the asset is dependent on the discounted value of the stream of cash flow it generates. Hence, other things remaining same if the cash flows are positively correlated and the discounting rates are same then the two asset classes would move in the same direction. Thus, relationship between stocks and bond prices are said to be theoretically correlated such that they both move in the same direction. However, it should be noted that there are different factors that impact the cash flow of both stocks and debt instruments. The cash flows in case of stock prices are driven by dividend (assuming dividend discount model) and in case of debt instruments are driven by the regular coupon payments and the principal payments. Discounting rates on the other hand are based on expectation of returns by the two classes of assets. The other factor that can cause a difference in the direction of price movement is inflation. An increase or decrease in inflation impact debt instruments more compared to the shares. This implies that if the prices of the stocks increase the prices of debt instruments would also increase and vice versa.

In 1993, a research was carried out by Campbell and team to determine the factors that move both the asset classes – stocks and debts. For this purpose, they researched on monthly prices of both the assets between the time period 1952 to 1987. The research showed that the stock prices were not impacted much by real interest rates and inflation. On the other hand inflation played an important role in determining the price of debt instruments. It was also observed that there is a higher volatility in the prices of debt compared to stocks. A research carried by Malcolm Baker and Jeffery Wrengler in 2011 prove that the relationship between bond and stock index is unstable. It also goes on to say that the stocks which give stable returns akin to bonds are more closely related to the government bonds. Hence, it can be concluded that though theoretically the price of a stock has a direct positive correlation with the price of debt empirically the same has not been established.

References:

·         Fama E.F., and G.W. Schwert, 1977, Asset Returns and Financial Economics, 115-46

·         Malcolm Baker and Jeffery Wurgler, 2012, Comovement and Predictability Relationship Between Bonds and Cross section of stocks

·         Cory Mitchell, 2011, Intermarket Relationships: Following The Cycle, Investopedia

·         IllhanDemiralp, Scott E Hein, 2010, Default Risk and Correlation of Stock Returns and Bond Yield Changes

·         Campbell R. Harvey, Journal of Portfolio Management, 1993, Errors in Means, Variances and Covariances on Optimal Portfolio Choice”

Author: Abhishek Sinha

Abhishek Sinha has approximately 8 year of experience in equity research, business research and consultancy. He has also had the privilege of managing a small portfolio of INR 3 million. However, his interest lies in teaching and "demystifying concepts." He has taught students right from the age of 3 years at PP1, to 40 years at executive courses and believes teaching is not about knowing the concepts; it is about relating the concepts to the audience. At present he is "gainfully employed" at Vignana Jyothi Institute of Management, Hyderabad; where he loves to teach finance to an enthusiastic bunch of management students. His hobbies include analyzing income statement, balance sheet and cash flow.> Google +