Robert Whitelaw Presentation
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
- 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
- Time-varying debt-equity correlations
- Term and default premiums
- Corporate bond betas
- Return predictability
- Inflation and security returns