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


  • 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


  • 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)]




Modified Duration: An Example



  • 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



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:
  • robertp12

  • 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


  • 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