On the Fundamental Relation Between Equity Returns and Interest Rates
JaewonChoi, UIUC
Matthew Richardson, NYU Stern
Robert Whitelaw, NYU Stern
The Impact of Interest Rates
Rolling Correlations
Correlations between returns and changes in interest rates
are ordered by priority in the capital structure
Results
Firms’ priority structure explains the relation between interest rates and corporate bond and equity returns
Higher leverage, lower priority ➜ more negative duration
Confirmed both at the firm and portfolio levels
Capital structure effects are important for interpreting existing evidence
Partially explains time-varying correlation between stocks and bonds
Reveals potentially misleading decomposition into default and term premiums
Outline
Theory based on capital structure priority
Data and stylized facts
Empirical evidence
Reinterpreting existing empirical results
A Contingent Claims Approach
Equity and debt are claims (options) on the underlying assets [Merton (1974), Rabinovitch(1989)]
Duration
Modified Duration: An Example
Data
Procedure
Map out firm’s capital structure
Construct returns for each security
Compute asset returns as weighted average of security returns
Summary statistics
Coverage: 89.6% of debt structure (VW)
Priority: ~30% with multiple priority bonds
Maturity: ~6 years on avg
Leverage: 0.75 avgand 0.32 median D/E (mkt values)
“Simple” Duration Estimates
Main Empirical Specification
R-Bond or equity returns
τ-Time to maturity
RA-Firm asset return
L-Firm leverage, log(book debt/market value of assets)
P-Bond priority, 0-1, 1 being the highest priority
Z-Fixed effects for convertible, callable, floating rate, sinking fund, and asset-backed bonds
Results
1. Assets are positive duration, more so for levered firms
2. Equity is negative duration (once you control for asset effects), more negative as leverage increases
3. Bonds are positive duration, which
a. Decreases with leverage
b. Increases with priority
Portfolio Level Analysis
1. Duration increases in priority
2. Duration increases in rating (decreases in leverage)
3. The differences are large between investment grade and high yield
Time-Varying Correlations between Equity and Debt
High correlation between debt-equity return correlation and market level leverage: 0.63
Decomposing Returns into Term and Default Premiums
The traditional approach:
But the default factor does not isolate default risk. Corporate bonds’ duration can be very short if they are low priority claims ➜ default factor contains negative term premium
In contrast, corporate minus “short-term” government bond isolates default risk.
Traditional Specification Misleading
Are AAA bonds really exposed to default risk?
Exposures to both term and default premiums are exaggerated
Conclusion
Capital structure matters!
Equity is not assets
Leverage and priority strongly influence interest rate sensitivity
Security-specific effects also exist in portfolios/indices
