Two essays on stock returns and bond yields

In this dissertation, I examine two different issues in the finance literature that are linked to each other, and I present the results in a two essay format. In the first essay, I investigate how the corporate bond yield changes and the stock returns of the issuing firm move together at different risk levels, in order to determine if the correlation between the yield changes of a bond and the returns on its issuing firm’s stocks (stock-bond correlation) is a proxy for default risk. In addition, I examine if the change in the stock-bond correlation and the probability of future credit rating changes are related. I find that as the default risks of bonds increase, the stock-bond correlations increase. This suggests that the stock-bond correlation of a firm is a proxy for its default risk. I also find that as the stock-bond correlation increases in absolute value, the probability of credit rating downgrades increases, which is consistent with the finding that the stock-bond correlation is a proxy for default risk. In the second essay, I investigate the effects of market power on average stock returns, and credit spreads. I estimate the Lerner index for each industry, in each year and use it as the measure of market power. I find that firms in industries with high market power earn lower average stock returns after controlling for size, book-to-market, beta, and industry concentration. I find that there is no statistically significant relationship between market power and credit spreads. I also examine if stock market reactions to credit ratings are related to the degree of market power in that industry. I find no relationship between stock price reactions to rating changes and market power.