Capital Structure Priority Effects in Durations, Stock-Bond Comovements, and Factor Pricing Models

Corporate bond valuation and hedging with stochastic interest rates and endogenous bankruptcy

Jaewon Choi, Matthew Richardson and Robert F Whitelaw

The Review of Asset Pricing Studies, 2022, vol. 12, issue 3, 706-753

Abstract: We show theoretically and empirically that the durations of corporate securities are monotonically related to their capital structure priority, with equity often having a negative duration. The magnitude of this effect increases with firm leverage. We use these insights to challenge existing results on stock-bond comovements and factor pricing. For example, though overlooked, higher leverage and lower priority reduce the correlation between corporate security and government bond returns, and these variables explain time-series and cross-sectional variation in correlations; traditional market model regressions significantly understate corporate bond betas; and regressions on standard term and default factors dramatically overstate interest rate and default risk. (JEL G12, G13)

Date: 2022
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