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George Bittlingmayer The University of Kansas School of Business bittlingmayer@ku.edu (785) 864-7541 Shane Moser The University of Mississippi School of Business smoser@bus.olemiss.edu (662) 915-1360

Abstract Do smaller, less liquid markets help predict prices in more liquid related markets? Using TRACE bond trade data for 1,958 bonds issued by 663 firms, we find that a decline of 10% in a firms bonds over one month is associated with a decline of 2.1% in its stock the following month. The coefficient is larger for firms with volatile stock, for more liquid and high-yield bonds, for zero-coupon bonds, and for bond price declines. These results support the view that informed trading may take place first in the less liquid market and that new information is often transmitted across related markets with a substantial lag.

* We thank Andre Liebenberg, Andy Puckett, Catherine Shenoy, Kelly Welch, and seminar participants at the 2008 FMA Conference and the 2008 CRSP Forum for their comments and suggestions.

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Kwan (1996), Hotchkiss and Ronen (2002) and 1 Gebhardt, Hvidkjaer, and Swaminathan (2005).

Abstract Do smaller, less liquid markets help predict prices in more liquid related markets? Using TRACE bond trade data for 1,958 bonds issued by 663 firms, we find that a decline of 10% in a firms bonds over one month is associated with a decline of 2.1% in its stock the following month. The coefficient is larger for firms with volatile stock, for more liquid and high-yield bonds, for zero-coupon bonds, and for bond price declines. These results support the view that informed trading may take place first in the less liquid market and that new information is often transmitted across related markets with a substantial lag.

1. Introduction Do smaller side markets anticipate returns in a larger, related market? And if one market leads, how long does it take for the other market to follow? A growing body of research suggests that less liquid markets, in particular debt markets, may in fact be venues for informed trading. Other work suggests that incorporation of information across related markets may take several weeks or longer. We investigate whether smaller-anticipates-bigger also holds for a corporations bonds and stocks, and whether it does so at monthly intervals. This seems implausible at first glance. Corporate bond trading is notoriously spotty, illiquid, and confined to less transparent over-thecounter markets. In fact, the early research on bond-stock interaction finds that a corporations bonds are less efficiently priced and lag its stock price.1 There are several reasons to take a new look. First, institutions dominate bond trading, while a mix of individual investors and institutions trade in the more transparent and liquid stock market. Arguably, stocks may be more subject to noise trading and implausibly optimistic assessments than bonds, setting the stage for stocks to lag bonds. Second, bond traders and

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Kwan (1996), Hotchkiss and Ronen (2002) and Gebhardt, Hvidkjaer, and Swaminathan (2005). 2

analysts may be better attuned to negative news and to what is happening with a companys balance sheet, with the implication that any lead for bonds may be stronger for negative news. Third, greater bond-market transparency with the advent of TRACE (Trade Reporting and Compliance Engine) in 2002 may have increased bond market efficiency.2 Finally, while an increasing body of evidence reveals lags between related markets at monthly intervals, the research to date on lags between bonds and stocks has focused on hourly and daily intervals. Our work examines the ability of a companys bonds to predict what will happen to its stock by using TRACE bond trade data for 1,958 bond-stock pairs covering 663 firms for the period July 2002 through December 2008. We regress monthly stock returns on lagged bond and lagged stock returns to assess whether past bond price movements anticipate stock price movements. It turns out they do. A 10% decline in a firms bond price in month t-1 is associated with a 2.1% decline of its stock price in month t. This effect appears most strongly among firms with volatile stock, and among high-yield bonds, high coupon bonds, zero-coupon bonds, and more liquid bonds. There is also appreciable evidence of an asymmetric effect, with bond price declines having a larger positive coefficient than bond price increases.3 Our results support the view that relatively small, illiquid markets often incorporate new information ahead of more liquid markets, and that they do so at monthly lags. The fact that these results are stronger for firms marked by greater uncertainty (high-yield, high coupon, high

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In addition, increased trading in credit default swaps written on corporate bonds may affect bond market efficiency. Asquith, Au, Covert, and Pathak (2010) report that bonds with CDS contracts are more actively lent. 3 We find the opposite situation for investment grade bonds, which are less volatile: bond price increases are associated with stock price declines in the ensuing month. This result is driven by the financial crisis year 2008, which comprises 30% of our sample. Even neglecting those special circumstances, the low volatility of investment grade bonds means the implied changes in the stock price fall in a narrow range. 3

volatility) and for more liquid bonds supports the inference that the balance of informed trading shifts toward bond markets and away from equity markets as the level of uncertainty increases. This finding is consistent with the conceptual models and empirical work reviewed below. Equity markets may not reflect all available information immediately because some information spreads slowly, because investors specialize in certain types of information, because they are distracted by other events, or because investor sentiment and constraints on short selling prevent immediate adjustment.

2. Literature Review and Hypothesis Development In a classic efficient markets framework, past information is irrelevant for future returns. However, a growing body of research supports the notion that asset prices sometimes react to new information with a lag. The best-known and now-classic examples include the momentum effect (stocks exhibit momentum over medium-term intervals of several months to a year) and the continued positive drift of stock prices after earnings announcements. Explanations for the momentum effect focus on psychological mechanisms that prevent the recognition of new information or prevent investors from acting on it.4 Other work documents instances in which prices in one market appear to anticipate prices in another, related market.5 Explanations for these results focus on investor inattention [e.g.,

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A recent summary of the evidence and debates on momentum appears in Novy-Marx (2012). Hirshleifer, Lim and Teoh (2009) support the distraction hypothesis for underreaction to earnings news. 5 Brennan, Jegadeesh, and Swaminathan (1993) report that portfolios of firms formed by stocks with many analysts lead those formed by stocks with few analysts. Hou (2007) finds that smallfirm stocks react with a lag to changes in price at large firms, primarily when the movement is negative. Dellavigna and Pollet (2009) find that the reaction to earnings announcements made on Fridays is more delayed than the reaction to earnings announcements made on other days of 4

Cohen and Frazzini (2009) and Dellavigna and Pollett (2009)] or the closely related concept of investor specialization or market segmentation [e.g., Menzly and Ozbas (2010)]. On this approach, which market leads and which lags depends on conditions in each market and can change as conditions change.

2.1 Good News and Bad News Equity markets do not seem to digest good and bad news the same way. The classic study by Bernard and Thomas (1989) found post-announcement drift when announced earnings come in below expectations. Chan (2003) finds strong drift after bad news but not good news, with the effect stronger among firms with lower capitalization and less liquid stocks. More recently, Hou (2007) attributes the lag of small stocks to changes at big stocks to the sluggish response of small firms to bad news at big firms. These results are relevant for our study since we find an asymmetric reaction of stocks to past bond price changes, with bond price declines associated with larger and more reliably negative lagged stock price changes, while bond price increases tend to be associated with smaller positive (and sometimes) negative stock price increases. This asymmetric response of stocks may be the result of short-sale constraints in equity markets that prevent timely

the week, offering support for the view that traders degree of distraction affects the speed of adjustment. Hong, Torous, and Valkanov (2007) find that sector returns anticipate general market returns, and Driesprong, Jacobsen, and Maat (2009) report that energy shocks lead individual national stock markets. Cohen and Frazzini (2008) find that buying firms whose customers had positive returns and shorting firms whose customers had negative returns yield excess returns of 1.55% per month. In Menzly and Oguzhan (2010), firms in economically related supplier and customer industries predict each others returns at a lag of one month. 5

adjustment6. Other factors, notably the inherent focus of bond markets on downside risk may also play a role. De Franco, Vasvari, and Wittenberg-Moerman (2009) report that bond analysts issue more negative reports and satisfy demand for negative information on the part of bond investors.7 As a companys credit situation worsens, the balance of attention shifts to the credit market and bad news. Finally, the intrinsic non-linear relationship between bond and stock prices also implies on average that bond price increases would be associated with smaller stock price changes than bond price declines.

2.2 Return Anticipation by Bond Markets and Related Venues Most work relating bond and stock markets focuses on the ability of a companys relatively liquid stock market to predict bond price movements. The lead of stocks over bonds tends to be quite strong. Research that looks at the ability of bond returns to predict stock returns offers mixed results. It is also based on substantially less data than we use here. Kwan (1996) represents an early study. He looks at 702 bonds for 327 firms for 1986 to 1990, regressing current weekly bond yield changes on lagging, current, and leading stock changes. Lagged stock returns have a negative effect on yields (hence, a positive effect on bond prices), while leading stock returns are not statistically significant, indicating that bond prices do not anticipate new developments in the stock market. Hotchkiss and Ronen (2002) look at 55 high-yield bonds for twenty firms on NASDs Fixed Income Pricing System (FIPS) and focus on short-term, hourly and daily, results for

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Miller (1977), Jones and Lamont (2002), and Boehme, Danielsen, and Sorescu (2006). Along the same lines, DeFond and Zhang (2011) find that bond markets anticipate bad news earnings surprises, but not good news earnings surprises ahead of stock markets. Consistent with the view that debt markets focus on bad news, Johnston, Markov and Ramnath (2009) report that companies in distress lose equity analyst coverage and receive more debt analyst coverage. 6

January October 1995. They find similar efficiency across stocks and bonds at intraday frequencies in reacting to earnings news. The small sample size and unrepresentative nature of the sample preclude generalization to all bonds or other periods. They also do not examine weekly or monthly lags, understandable given the nature of their data. Gebhardt, Hvidkjaer, and Swaminathan (2005) look at much longer frequencies and find evidence of spillover from equities to bonds at annual intervals (companies whose stocks do well have bonds that do well the following year), based on data from 1973 through 1996. Their Table 2 forms portfolios of firms on the basis of the previous six-months bond returns and various bond characteristics (rating, trading volume, face value, and variance), and tracks the stock returns over the ensuing two to seven months after portfolio formation. There is no apparent relationship. Again, their period predates greater transparency under TRACE and the advent of the CDS market for corporate bonds, and they focus on returns over very long periods and longer lead-lag relationships than we examine here. Allen & Gottesman (2006) find significant cross-influences between a firms stock and its traded bank loans at a weekly lag and conclude that the two markets are integrated, with influences running in both directions. Their sample encompasses 763 borrowers over the period 1999-2003, and they focus on statistical tests of Granger causation rather than the algebraic sign and magnitude of the link. Downing, Underwood, and Xing (2009) take up both hourly and daily returns with the same TRACE data we use, but for a more limited period, October 2004 through December 2005 (rather than December 2008). They focus on 3,000 bonds issued by 439 firms and the associated stocks, and run Granger-causality tests using hourly and daily returns, with a maximum daily lag of five days. Their focus is on the influence of stocks on bonds, and they find that stock returns 7

predict returns on BBB- and junk-rated bonds at daily and hourly frequencies. They do test influence in the other direction, and their tests of cross-effects of bonds on stocks for individual bonds reject the null hypothesis of no effect for a slightly larger fraction of bonds than would be expected by chance, at least for BBB- and Junk-rated bonds (Table 5, p. 1093). However, their lags are quite short and their data do not include later years, when many more bonds came to be included in TRACE and the bond markets experienced a burst of volatility. Altman, Gande, and Saunders (2010) show that fluctuations in traded bank loans anticipate fluctuations in bonds around defaults for a sample of 176 firms. The reverse is not true: bond price changes do not anticipate changes in the price of traded bank loans. They examine lag lengths of ten days, and their coverage runs from November 1999 through October 2007. The authors find confirmation for the view that traded bank loans reflect more informed trading because banks have a continued incentive to monitor the borrowers. We have already summarized the prior research showing that stocks lead bonds, and do so in a robust fashion. Nonetheless, some evidence exists that bond analysts contribute to a more efficient equity market. Gurun, Johnston, and Markov (2011) look at the effect of bond sell-side reports for 921 companies over the period July 2002 through December 2004, and find that bond prices lag stock prices less in the presence of sell-side reports. Ronen and Zhou (2010) provide a closely related and complementary line of inquiry. They look at the microstructure of the bond market and the factors that affect its efficiency. They also emphasize the role of liquidity, an emphasis consistent with our findings below. The biggest difference is their focus on comparatively short periods of ten hours or less. In addition, they cover only 66 firms for the period January 2003 through December 2006.

2.3 The Question of Lags Nearly all of the work to date looks at relatively short lags: hourly to one week [Kwan (1996), Hotchkiss and Ronen (2002), Downing, Underwood and Xing (2009), and Ronen and Zhou (2010)]. The exception is Gebhardt, Hvidkjaer, and Swaminathan (2005), who look at crossrelationships at six-month to annual intervals. This leaves a gap, especially since in other contexts, it is clear that asset prices reflect certain types of information with a lag of several weeks to several months. Bernard and Thomas (1989) find post-earnings-announcement drift up to sixty days. Karpoff & Lou (2010) show that for stocks of companies that reveal mis-stated earnings, short interest anticipates the restatement and stock price drop as far as 19 months in advance. Finally, as mentioned earlier, Hong, Valkanov, and Torous (2007), Driesprong, Jacobsen, and Maat (2008) and Cohen and Frazzini (2008) find significant lags in related markets at monthly intervals.

2.4 Conceptual Framework Under what conditions do asset prices reflect information with a lag? More specifically in our context, when is there a significant lagged cross-correlation between related markets? Some recent work emphasizes the slow spread or slow realization of information in markets that appear to be liquid. Hong and Stein (1999) develop a model in which information spreads slowly among informed traders, leading to short-term momentum and long-term reversal. This is the framework adopted by Hong, Torous, and Valkanov (2007) and by Dreisprong, Jacobsen, and Maat (2008) to explain why aggregate stock markets react with a lag to developments in major sectors such as energy. Cohen and Frazzini (2008) invoke the same literature to explain the lead-lag relationship between the stocks of customers and suppliers. On 9

this view, participants in the lagging market have limited ability to evaluate the information generated or reflected in the leading market. Note that in the current context, a particular market e.g., the bond market could lead in recognizing one type of information (such as the likelihood of default) and lag in recognizing another type of information (such as an uptick in revenue). An alternative explanation for why one market might lag the other appeals to investor sentiment. For example, Baker and Wurgler (2007) propose that small companies, companies in growth industries, and others that may be subject to investor sentiment may be pulled from true value. These are also stocks that are hard to arbitrage and hard to value. One might argue that bond markets are relatively less susceptible though clearly not immune to these waves of sentiment. Thus, bond markets would lead stock markets when these waves of sentiment sweep over stocks. The slow spread of information, investor inattention or specialization, and the role of investor sentiment provide mechanisms for the central result that bond price movements anticipate future stock price movements. These explanations also suggest that the lead of bonds over stocks will be more pronounced when bond trading is relatively liquid, and when uncertainty levels and downside risk are high.

3. Data Description In an effort to bring transparency to the over-the-counter (OTC) corporate bond market, the National Association of Securities Dealers (NASD) began a real-time price dissemination service called the Trade Reporting and Compliance Engine (TRACE) on July 1, 2002. As a result, 100% of OTC activity representing over 99% of total U.S. corporate bond market activity can be 10

accessed through the TRACE system today. This unique dataset allows us to assess the informational efficiency of the corporate bond market relative to the stock market on a scale much larger than past research allowed (NASD TRACE Fact Book (2006)). The TRACE system has evolved. Phase I of TRACE was launched on July 1, 2002, at which time it only included Investment Grade debt securities that had an initial issue of $1 billion or more (along with 50 high-yield FIPS securities). By the end of 2002, NASD was disseminating information through TRACE on roughly 520 securities (NASD TRACE Fact Book (2006)). On April 14, 2003, TRACE implemented Phase II, which brought in all Investment Grade securities of at least $100 million par value that were rated A3/A- or higher, a group of 120 Investment Grade securities rated Baa/BBB, and 50 High-Yield bonds. This extended the total number of bonds covered to roughly 4,650 (NASD TRACE Fact Book (2006)). The last phase (Phase III) began on October 1, 2004, and was fully effective on February 7, 2005. TRACE now captures 100% of OTC transactions (roughly 99% of all public transactions). During the introduction of TRACE, the time in which transactions are required to be reported has been reduced gradually. On July 1, 2002, that requirement was 75 minutes. It declined first to 45 minutes on October 1, 2003, next to 30 minutes on October 1, 2004, and finally to 15 minutes on July 1, 2005 (NASD TRACE Fact Book (2006)). A typical day of bond trading is characterized by large intra-day price differences that are correlated with trade size, as documented by Bessembinder, Maxwell, and Venkataraman (2006). In other words, smaller trades have the potential to introduce greater noise due to bid-ask bounce. Since small trades may not reflect the efficient price of the underlying bond, we follow Bessembinder, Kahle, Maxwell, and Xu (2009) and eliminate all trades whose value is less than 11

$100,000 and calculate a daily trade-weighted price. This is necessary because the TRACE system did not indicate whether the trade was initiated with a buy or a sell until 2009. This means nearly every daily bond price in our data set reflects trades that happened before the last daily stock transaction, making it more difficult to find the results we do, i.e. bonds leading stocks. Additionally, we eliminate any bond trade that has been canceled or corrected. We also drop trades with prices containing dealer commissions. It is well known that the corporate bond market is markedly less liquid than the market for corporate equities. For this reason, we only include bonds in our sample that trade on average once per day over the sample period, following Downing, Underwood, and Xing (2009). We utilize a sample period from July 1, 2002 (the day Phase I started) to December 31, 2008 so as to maximize the total types of bonds in our sample. Many of the high-yield bonds were not included in Phases I or II. During the sample period, approximately 30,000 bonds from roughly 3,200 companies traded. However, since many of these bonds are extremely illiquid, our final sample consists of 1,958 bonds from 663 companies. We then take our sample of bond prices and merge it to stock prices from CRSP by company. Because of the fact that bonds dont trade every day, we impute a zero return for the bond on those days so as to have a full twenty days from which to calculate our monthly returns. Even then, there are occasionally monthly periods where the bond does not trade. It should be noted that this biases our results against finding a relationship between current bond price changes and future stock price changes. Table 1 provides summary statistics for our final sample. The mean coupon rate is 5.78%, while the median is 5.90%, indicating there is not a great amount of skewness. The upper 12

quartile is 7.0%, and the lower is 4.9%. Most of the bonds (61%) are investment grade, while 39% are high-yield. Turning to liquidity measures, the mean bond in our sample trades on 62% of possible trading days, while the median is 60%. The upper quartile is 76%, and the lower is 48%. The other liquidity measures, trades per day and average daily volume, display a bit more right skewness. The mean bond in our sample trades 2.7 times per day, while the median is 1.9. The upper quartile is 3.1, and the lower is 1.4. Keep in mind that our sample is filtered so as to only include bonds that trade at least once per day (on average). The mean bond in our sample has an average daily volume of $4.0 million, while the median is $2.7 million. (The dollar volume data are conditional on a bond trading.) The upper quartile is $4.6 million and the lower is $1.6 million. On the day of the trade, the mean bond's years-to-maturity is 10.4. The median is 7.2, indicating substantial right skewness here, as expected. The upper quartile is 10.6, while the lower is 4.7. For every trading day in our sample, we calculate an adjusted monthly (twenty-tradingday) bond return. Table 2 provides summary statistics for these returns broken down by some relevant characteristics. Because we are interested in the portion of the bonds return that stems from nonsystematic factors, we calculate abnormal bond returns in the spirit of Cai, Helwege, and Warga (2007). We do this by splitting the sample into terciles by years-to-maturity. The sample is also split by grade (high-yield vs. investment-grade). Thus, we calculate equallyweighted portfolio returns for each of the six buckets (three maturity buckets by two grade buckets). This is the return that we subtract from the bonds return to arrive at an abnormal return. The typical corporate bonds monthly abnormal return is negative 48 basis points (median = -1.4 basis points), and the standard deviation is 581 basis points. As the breakdown by year 13

shows, the negative average return stems from 2008, which is also heavily weighted in our sample. Higher coupon and higher-yield bonds exhibit lower returns and higher volatility. Longer-term bonds dont appear to be associated with either returns or volatility. Lastly and not surprisingly for this time period, the corporate bonds of the most volatile stocks exhibited the lowest returns and the highest volatility.

4. Econometric Specification Consider bond-stock pair i in a pooled regression model. Analogous to our treatment of bonds, for each stock in our sample, we calculate an abnormal return by subtracting the return on the S&P 500. The abnormal return of stock i in month t, rsit, is represented as a function of the lagged abnormal returns on bonds over the three previous months, rbi,t-k, k = 1, 2, 3 and also as a function of the lagged abnormal returns on stocks in the same three previous months, rsi,t-k, k = 1, 2, 3. In addition, to allow for non-linearities, we add an interaction with an indicator variable Bi,t-k, k = 1, 2, or 3, that takes on the value of one if the abnormal bond return in month 1, 2, or 3, respectively, was negative. Si,t-k, k = 1, 2, or 3 is defined analogously for negative stock price changes in prior months. Thus: !"!" = ! +

! ! ! ,! ,!

!!!! !"!"!! +

! ! ! ,! ,!

+ !"!!! !"!"!! +

! ! ! ,! ,! ! ! ! ,! ,!

This model implies twelve slope coefficients. In the work below, we report all twelve in Table 3, Panel A, for the full sample. However, in subsequent tables, which are based on partitions of the 14

data, we report only the coefficients on the first lag of the two bond returns, t-1 and t-1. The coefficient t-1 measures the slope between one-month lagged bond returns and the current month stock return, and the coefficient t-1 measures the incremental slope when the lagged bond return is negative. The sum of the two provides the net empirical relationship between lagged bond returns and current stock returns when bond returns are negative.8

5. Core Empirical Results Table 3 shows the results for Equation (1) for our entire sample of 1,958 bond-stock pairs over the period July 2002 through December 2008. In a simple model that includes only lagged bond returns over the previous three months (Column 1), the one-month lagged bond return has a significant coefficient of 0.111. Adding lagged stock returns (Column 2) increases the coefficient on the one-month bond lag slightly, to 0.136. The major change in the coefficient occurs when we allow for an asymmetric functional form (Column 3). The simple return has a slightly negative and insignificant coefficient, -0.030, but the coefficient on the one-month lagged bond price decline is 0.242. Thus, the net implied effect of a bond price decline for the sample of bonds as a whole is 0.212 (= -0.030 + 0.242). Panel B shows the results for the same regressions but limited to high-yield bonds only. In this case, the coefficients increase for the simple model and the model with lagged stock returns (Columns 1 and 2) compared to the base case of all bonds, increasing from 0.111 to 0.200 and 0.136 to 0.226. The full model (Column 3) for high-yield bonds shows a strongly positive

In this paragraph and henceforth, bond return and stock return refer to the abnormal, or adjusted, returns. 15

coefficient for simple bond returns, 0.177, and a slightly stronger coefficient for declines, 0.221 (= 0.177 + 0.044). Panel C has results for investment grade bonds. In contrast to the high-yield results, this shows a negative association between lagged bond price changes and current stock returns. The full model (Column 3) reveals a negative relationship for bond price increases of -0.296, while the coefficient for bond declines is slightly positive at 0.035 (=-0.296+0.331). It turns out the lagged negative association for investment grade bond price increases is substantially weaker for liquid bonds, as we will show in our discussion of Table 4 below. Figure 1 shows the simple bivariate relationship between prior month excess bond returns and current month excess stock returns. The line labeled overall shows all bonds, while the other two lines show the results separately for high-yield and investment grade bonds. For all bonds, we form deciles based on the prior month excess bond return and compute the current month excess stock return. The scatter plot shows that increases in bond price on average have little or no relationship with subsequent stock returns. In contrast, declines of bonds are associated with lower lagged stock declines. The plots broken down by bond grade show that the positive association is driven entirely by high-yield bonds. In addition, note that increases in prior month high-yield bond prices seem to have no effect on current month stock prices, while declines are associated with substantial declines in stock prices. (The highest, positive decile of prior month bond returns is associated with higher current month stock returns.) In contrast to the high-yield results, the plot for investment-grade bonds shows a negative relationship, though with a smaller absolute value, consistent with the regression results in Table 3. Two points are worth emphasizing. First, these plots are based on all bonds that trade an 16

average of once a day or more. We shall see that the result for the most liquid bonds is different. Second, the relatively small dispersion of investment grade bond returns means that the implied dispersion of stock returns in the subsequent month is also very small. A decline of 5 percent is the average for the lowest decile of investment grade bond changes. Based on both the regression results and the plots in Figure 1, such a prior month bond price decline implies a relatively small increase in the stock price, roughly a half percent. The analysis in Table 3 suffers from the defect that a firm with multiple bonds in our final data set is represented multiple times, with a mix of bonds of differing liquidity. To address both issues, Table 4 repeats the analysis of Table 3, but confines the analysis to a firms most liquid bond or to an equally-weighted portfolio of all its bonds. Liquidity is measured three ways: by trades per day, percentage of days traded, and highest daily volume. For all three measures and the portfolio of all bonds, the results for all grades (Panel A) show slightly higher coefficients in the Model 2 specification (no interaction term). The estimated coefficient falls in the range of 0.158 to 0.169, slightly more than the 0.136 estimated in Table 3. Inclusion of an interaction term, Model 3, yields a positive effect of 0.011 to 0.027 for bond price increases, and substantially larger effects, between 0.230 and 0.247, for bond price declines. (For example, for the most liquid bonds the net effect of bond price declines is 0.247 = 0.022 + 0.225.) When we turn to the results based on high-yield bonds only (Panel B), the simple coefficient on the prior month bond return (with no interaction term) is substantially higher, in the range of 0.176 to 0.188, and uniformly statistically significant. Allowing for an interaction term, the net coefficient attached to bond price declines is roughly 0.24 across the four measures of bond returns. (For example, the coefficients on the most liquid bonds sum to 0.243 = 0.060 + 0.183.) Contrast this to the results in Table 3, Panel B, showing the results across all high-yield 17

bonds, liquid and less liquid, where the effect was roughly the same, 0.221, but showing weak signs of an asymmetric effect of bond price declines. The stronger and very stable results in Table 4, Panel B, for high-yield, liquid bonds supports the notion that these bonds are the venue for informed trading, particularly when bond prices decline. The importance of liquidity is reinforced by the results for investment-grade bonds (Panel C). The regressions for a firms most liquid bonds now yield a positive (rather than negative) simple coefficient on prior bond return. Note however, that these coefficients, in the range of 0.028 to 0.050 are small compared to high-yield bonds (Panel B). The portfolio of bonds, which includes less liquid bonds, has a small though still significant coefficient of -0.012. When the specification for investment grade bonds allows for interaction with a bond declines, the results indicate a lopsided, inverted-V, with a moderately negative coefficient for bond price increases (falling in the range of -0.104 to -0.136), and a somewhat larger positive coefficient for bond price decreases. Thus, for the estimate based on bonds with the largest number of trades per day, the net coefficient for declines is 0.179 (= 0.104 + 0.283). It bears emphasis that even for the case of investment grade bonds, weighting all firms equally and using either the most liquid bonds or a portfolio of bonds, bond price declines in the prior month are associated with stock price declines in the current month. Figures 2a and 2b show corresponding simple bivariate relationships for liquid bonds and the portfolios of bonds. For high-yield bonds (Figure 2a), there is a strong positive, and nearly linear, bivariate relationship. Again, there seems to be a strong asymmetry around zero, with small bond price increases having little effect on stock returns while relatively small bond price declines have larger negative effects. Note that for high-yield bonds, the five ways of measuring

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bond returns (the three measures of liquidity, the portfolio of all of a firms bonds, and all high yield bonds considered separately) yield very similar results. For the most liquid investment-grade bonds (Figure 2b), there is a small, positive relationship, consistent with the regression results without an interaction term (Table 4, Panel C, Model 2). The three measures of liquidity and the portfolio of all bonds yield similar plots. There is an apparent contradiction with these results (a very flat V-shape) and what we found based on an interaction term (Model 3), which showed an inverted-V relationship. However, those regressions include both lagged stock returns and additional bond lags. It also bears emphasizing again that the net apparent effect on stock price is very small.

6. Robustness Checks, Uncertainty, and Liquidity In the subsequent tables we do two things. First, we assess the robustness of the basic finding that lagged bond returns predict current stock returns by examining how well that finding holds up across time periods and allowing for changes in a firms stock price. Second, we assess explanations for this result by examining the influence of bond and firm characteristics that proxy for underlying uncertainty and the liquidity of the bond and stock markets. One important issue is whether the result holds up across time periods, in particular before and during the 2007-2008 financial crisis. Table 5 breaks down the results by 2005-2006, 2007 and 2008. (The omitted years 2002-2004 account for only 13% of our sample and are omitted because TRACE was not comprehensive at this time see Section 3.) We combine 2005 and 2006 for parsimony and to provide sample sizes roughly comparable to those for 2007 and 2008. The simple coefficient for all grades (Panel A, Model 2) shows comparatively small but statistically significant coefficients, 0.096, 0.163, and 0.141 for the three periods. The estimates 19

for high-yield bonds (top line, Panel B) are substantially higher, 0.124, 0.165 and 0.247, and it bears noting, uniformly positive across years. Thus we conclude that the positive relationship between prior month bond returns and current month stock returns is not an artifact of 2008. In contrast, the results for investment-grade bonds show a small and insignificant coefficient for 2005-2006, a positive coefficient of 0.146 for 2007 and a negative coefficient of 0.156 for 2008. Arguably, the weak but persistent negative relationship between prior month bond returns and current stock returns for investment grade bonds in our sample as a whole depends on the inclusion of less liquid bonds (Table 4s result) as well as the experience of a particular year, 2008, the finding here. A second question is the effect of prior stock returns. Is there a different effect of lagged bond price changes when a firms stock increases or decreases? Perhaps the apparent lagged effect of bond returns is due to momentum in stocks. In the previous tables, we included lagged stock returns, but this may not capture subtle interaction effects. Table 6 runs the same regressions as Table 3, but splits the sample based on the stock return (up or down) in the lagged month. (It also does not include prior stock price movements, since this is the variable used to divide the sample.) For all grades (Panel A), the simple coefficient is still positive at 0.145 when stocks decline in the prior month. The coefficient conditional on a prior month stock price increase is smaller, 0.035, and not significant. When confined to high-yield bonds (Panel B), the coefficient is appreciably higher in the wake of both declines and increases in the stock price, 0.204 and 0.136. Interestingly for the subset of high-yield bonds, when a firms stock price declines, positive bond price increases have a large effect on its stock the next month, as shown by the coefficient of 0.521. In contrast, when the firms stock increases, bond price declines have a 20

larger effect. This is consistent with the high-yield bond market tempering the stock markets pessimistic assessment (stock down column) and tempering its optimistic assessment (stock up column) when the stock and bond market disagree. Finally, consider the result for investment-grade bonds when stock prices decline in the prior month (Panel C). The simple model (Model 2) shows a nearly identical, small negative effect, -0.089 and -0.110, similar to Models 1 and 2 in Table 3. A bonds coupon serves as a proxy for level of risk, and since it is determined at issuance, it is an ex ante proxy. Table 7 shows results based on coupon quartiles, plus zerocoupon bonds. In the simple model without interaction effects for all bonds (Panel A), zerocoupon bonds and the highest quartile have the largest coefficients, 0.179 and 0.277. This is consistent with these bonds being the instruments used by riskier firms. The results also show a strong asymmetric effect of bond price declines (except for the largest coupon quartile). For zero-coupon bonds, the net coefficient is 0.296 (= 0.23 + 0.273). The first three quartiles show somewhat smaller net effects of bond price declines. Turning to high-yield bonds (Panel B), the zero-coupon bonds show a very large effect from declines, 0.430 (= 0.083 + 0.347). In contrast, the top three quartiles among high-yield bonds have a positive, largely linear relationship with next months stock returns. Finally, for the less volatile investment grade bonds (Panel C), there is no relationship, or it is negative for bond price increases. Summarizing, declines in zero-coupon high-yield bonds are associated with future stock price declines, and movements of higher coupon, high-yield bonds also predict future stock

21

prices. These are the categories with higher risk, thus supporting the view that attention paid to that risk results in new information being incorporated in those bonds ahead of equity markets.9 Table 8 breaks down the results by maturity quintiles. At first glance, it would seem that long-term bonds have more to tell us about a companys prospects. However, the degree to which bonds of varying maturity reflect changing risk depends on the term structure of that risk. One measure comes from the summary statistics in Table 2 (Panel D: Years to Maturity), which indicate that while the abnormal returns of long-term bonds have a higher inter-quartile range (75%ile minus 25%ile), their standard deviation does not increase with maturity. Thus, the results based on maturity quintiles will serve as a check on the robustness of our results. For regressions based on all bonds (Panel A), bond price declines in the prior month are associated with stock price declines, but the simple (Model 2) coefficient declines with maturity quintiles. When restricted to high-yield bonds (Panel B), there is still a strong positive relationship, with coefficients ranging from 0.273 (shortest maturity) to 0.154 (longest), but there is less evidence of an asymmetric effect of bond price declines. As we found for previous cuts of the data, there is a comparatively weak average effect among the investment grade bonds (Panel C), with consistent evidence of a negative effect of bond price increases. Stock volatility is a measure of uncertainty and noise trading. It is also associated with lower returns in our sample. Table 9 shows regression results stratified by the volatility of a firms stock. If stock volatility delays the recognition of new information, we expect firms with a more volatile stock to show more evidence of bond price changes leading stock price changes. For the least volatile of all bonds (Q1 and Q2 in Panel A), the association between prior bond

9

Since we calculate bond returns from prices net of accrued interest, and since bond coupon rates represent the difference between the actual return and the clean price, these regressions also, in effect, adjust for accrued interest. 22

price changes and current stock price movements is zero or negative, mirroring what we found earlier for investment-grade bonds. However, for the more volatile categories, the simple coefficient turns positive. However, the most dramatic and consistent results emerge from the specification that allows for asymmetric effects. For Q3-Q5, the interaction terms coefficient steadily increases from 0.190, to 0.225 to 0.344. The results for high-yield bonds (Panel B) show the same tendency for a stronger estimated relationship as volatility increases. The simple coefficient for Q5 of 0.306 (Panel B) is among the highest we have for this specification. Finally, the regressions based on investment grade bonds show a predominantly negative relationship. For the specification that allows for asymmetric effects, as stock volatility increases, the familiar pattern for investment grade emerges, with bond price increases associated with lower subsequent stock returns, but the net effect for bond price declines being zero or positive. The very strong negative coefficients for Q4 and Q5 are consistent with our findings for 2008. Our earlier results in Table 4 underscored the importance of bond liquidity. In Table 10 we analyze this in greater detail by looking at three measures of liquidity: trades per day (Panel A), percentage of days traded (Panel B), and daily dollar volume (Panel C). For the simple relationship without interaction effects, the estimated coefficient does not increase with greater bond liquidity. In fact, for the daily volume measure (Panel C), the simple coefficient declines for more liquid bonds. It is noteworthy that all coefficients from the simple regressions (Model 2) are positive across the different liquidity measures and quintiles, falling in the range from 0.048 to 0.200. However, with interaction effects, higher liquidity is associated with a larger coefficient when bond prices decline across all three measures of liquidity. In particular, the asymmetry increases strongly for Q4 and Q5 on all three measures. (The strong inverted-V 23

relationship for highest quintile of the daily volume measure again suggests the effect of 2008.) The greater sensitivity of stock prices to past bond price declines for more liquid bonds supports the view that bond markets become the venue for trading when bad news hits companies.

7. Conclusion What does the corporate bond market know that the equity market does not? We have tried to provide an answer that is richer and more complete than work on this subject to date. First, we bring to bear a much larger dataset than previous studies. The TRACE data are new, and the number of bonds included has increased substantially each year. Second, we include the crisis year 2008, when both the stock and bond markets experienced unusually large changes. Third, we focus on one-month lags, which other studies have not yet addressed. Cross-market lagged effects at that frequency have been found for other linked markets, but have received little attention in the bond market. We find that lagged bond returns do in fact provide incremental information about the future course of stock returns. The effect is evident both in our regressions, which include lagged bond and stock returns over three months, and in our scatter plots. Past bond price changes are associated with current stock price changes. The implied effect for bonds as a whole (and especially for important sub-categories such as high-yield bonds, more liquid bonds, zerocoupon and high-coupon bonds, and companies with volatile stock) is appreciable and economically significant. A 10 percent prior month decline in the value of high-yield bonds (a bit more than the standard deviation of 8.15%) is associated with a decline in a firms stock of 2.2% to 4.3%. More liquid investment grade bonds are subject to a similar effect, though given the low

24

volatility of those bonds and the lower coefficient, the economic significance is comparatively muted. Our work provides support for an important stylized fact: bond prices partially anticipate stock prices. The relatively small and illiquid over-the-counter market for a corporations bonds contains information about the future course of its stocks. This result is consistent with a growing body of literature that finds lags in the flow of information across related markets. It thus contributes to our understanding of how market prices come to reflect new information.

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References Altman, Edward, Amar Gande, and Anthony Saunders, 2010, Bank debt versus bond debt: Evidence from secondary market prices, Journal of Money, Credit and Banking, 42, 755-767. Allen, Linda, and Aron G. Gottesman, 2006, The informational efficiency of the equity market as compared to the syndicated bank loan market, Journal of Financial Services Research, 30, 542. Asquith, Paul, Andrea S. Au, Thomas R. Covert, and Parag A. Pathak, 2010, The market for borrowing corporate bonds, NBER Working Paper 16282. Baker, Malcolm, and Jeffrey Wurgler, 2007, Investor sentiment in the stock market, Journal of Economic Perspectives 21, 129-151. Bernard, V.L., and Thomas, J.K., 1989, Evidence that stock prices do not fully reflect the implications of current earnings for future earnings, Journal of Accounting and Economics 13, 305340. Bessembinder, Hendrik, Kathleen M. Kahle,William F. Maxwell, and Danielle Xu, 2009, Measuring abnormal bond performance, Review of Financial Studies, 22, 4219-4285. Bessembinder, Hendrik, William Maxwell, and Kumar Venkataraman, 2006, Market transparency, liquidity externalities, and institutional trading costs in corporate bonds, Journal of Financial Economics, 82, 251-288. Boehme, Rodney, Bartley Danielsen, and Sorin Sorescu, 2006, Short-sale constraints, differences of opinion, and overvaluation, Journal of Financial and Quantitative Analysis, 41 (2), 455-487. Brennan, Michael J., Narasimhan Jegadeesh, and Bhaskaran Swaminathan, 1993, Investment analysis and the adjustment of stock prices to common information, Review of Financial Studies, 6, 799-824. Cai, Nianyun (Kelly), Jean Helwege, and Arthur Warga, 2007, Underpricing in the Corporate Bond Market, Review of Financial Studies 20, 20212046. Chan, Wesley S., 2003, Stock price reaction to news and no-news: Drift and reversal after headlines, Journal of Financial Economics, 70, 223-260. Cohen, Lauren, and Andrea Frazzini, 2008, Economic links and predictable returns, Journal of Finance, 63 (4), 1977-2011. DeFond, Mark, and Jieying Zhang, 2011, The timeliness of the bond markets reaction to bad news earnings surprises, Working Paper, University of Southern California. 26

De Franco, Gus, Florin P. Vasvari, and Regina Wittenberg-Moerman, 2009, The informational role of bond analysts, Journal of Accounting Research, 47 (December) 1201-1248. Dellavigna, Stefano, and Joshua M. Pollett, 2009, Investor inattention and Friday earnings announcements, Journal of Finance, 64, 709-749. Downing, Chris, Shane Underwood, and Yuhang Xing, 2009, The relative informational efficiency of stocks and bonds: An intraday analysis, Journal of Financial and Quantitative Analysis, 44, 1081-1102. Driesprong, Gerben, Ben Jacobsen, and Benjamin Maat, 2008, Striking oil: Another puzzle? Journal of Financial Economics, 89, 307-327. Gebhardt, William R., Soeren Hvidkjaer, Bhaskaran Swaminathan, 2005, Stock and bond market interaction: Does momentum spill over? Journal of Financial Economics, 75, 651-690. Gurun, Umit G., Rick Johnston, and Stanimir Markov, 2011, Sell-side debt analysts and market efficiency, Working Paper, September 28, 2011 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1148898 Hirshleifer, David, Sonya Seongyeon Lim, and Siew Hong Teoh, Driven to distraction: Extraneous events and underreaction to earnings news, Journal of Finance, 64 (5) 2289-2325. Hong, Harrison, Walter Torous, and Rossen Valkanov, 2007, Do industries lead stock markets? Journal of Financial Economics, 83, 367-396. Hong, Harrison, and Jeremy C. Stein, 1999, A unified theory of underreaction, momentum trading, and overreaction in asset markets, Journal of Finance, 54, 2143-2184. Hotchkiss, Edith S., and Tavey Ronen, 2002. The informational efficiency of the corporate bond market: An intraday analysis, The Review of Financial Studies, 15, 1325-1354. Hou, Kewei, 2007, Industry information diffusion and the lead-lag effect in stock returns, Review of Financial Studies, 24, 1112-1138. Johnston, Rick, Stanimir Markov, and Sundaresh Ramnath, 2009, Sell-side debt analysts, Journal of Accounting and Economics, 47, 91-107. Jones, Charles, and Owen Lamont, 2002, Short-sale constraints and stock returns, Journal of Financial Economics, 66, 207-239. Karpoff, Jonathan M., and Xiaoxia Lou, 2010, Short sellers and financial misconduct, Journal of Finance, 65, 1879-1913.

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Kwan, Simon, 1996, Firm specific information and correlation between individual stocks and bonds, Journal of Financial Economics, 40, 63-80. Menzly, Lior, and Oguzhan Ozbas, 2010, Market segmentation and cross-predictability of returns, Journal of Finance, 65, 1555-1580. Miller, Edward M., 1977, Risk, uncertainty, and divergence of opinion, Journal of Finance, 32 (4), 1151-1168. Novy-Marx, Robert, 2012, Is momentum really momentum? Journal of Financial Economics 103, 429-453. Ronen, Tavy, and Xing Zhou, 2010, Where did all the information go? Trade in the corporate bond market, Working Paper, Rutgers Business School http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1573535 TRACE Fact Book, National Association of Securities Dealers, 2006.

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Table 1 Summary Statistics for Corporate Bonds These statistics are calculated for the corporate bonds already sifted for liquidity, i.e., at least one trade per day, on average. The sample was obtained from TRACE (Trade Reporting and Compliance Engine) and spans July 2002 through December 2008. % High-Yield is the percentage of bonds in the sample that are above BBB (S&P) and Baa (Moody's). Coupon is the annual coupon that the bond pays. Years to Maturity is the number of years left before the bond matures, calculated on a daily basis. Trades per Day is the average number of daily trades for the bond. % Days Traded is the percentage of days the bond trades at least once. Daily Volume is the average daily volume over the bonds life during our sample period, measured in thousands of dollars. The Liquidity Measures are calculated at the CUSIP level, whereas the rest are calculated at the TRACE bond symbol level. Obs 1,993 1,993 1,993 1,958 1,958 1,958 Mean 39.1 5.78 10.41 2.72 62.3 3,995 St. dev. 2.12 8.92 2.45 17.3 4,348 Min 0.0 0.00 0.01 1.00 12.9 328 25%ile 0.0 4.90 4.67 1.35 48.4 1,557 Median 0.0 5.90 7.23 1.94 60.0 2,663 75%ile 100.0 7.00 10.56 3.10 75.5 4,603 Max 100.0 13.50 80.08 35.51 99.4 54,818

% High-Yield Coupon (%) Years to Maturity Liquidity Measures Trades per Day % Days Traded Daily Volume

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Table 2 Statistical Summary of Abnormal Bond Returns The following statistics are based on all monthly (4-week) abnormal bond returns for the 1,958 corporate bonds already sifted for liquidity, i.e., at least one trade per day, on average. Abnormal bond returns are calculated by subtracting the equally-weighted mean of all the bonds in the bucket of a 2X3 matrix (grade by maturity) in which the bond belongs. The sample was obtained from TRACE (Trade Reporting and Compliance Engine) and spans July 2002 through December 2008. Coupon is the annual coupon that the bond pays. High-Yield is a bond that is below BBB (S&P) and Baa (Moody's), whereas Investment-grade is at or above. Years to Maturity is the number of years left before the bond matures. Stock Return - St. Dev. is the standard deviation of the matching stock's monthly return, obtained from CRSP. Q1-Q5 represent quintiles 1-5 calculated at the bond level. Bond returns are Winsorized at the 0.1% level to reduce the impact of extreme outliers. This makes the maximum bond return 83.51% and the minimum bond return -43.71%. Obs 1,532,775 17,796 68,005 113,249 216,265 286,117 368,144 463,199 925,462 607,313 302,609 292,983 247,757 312,568 376,858 511,846 463,070 165,368 141,690 249,151 371,631 334,201 302,974 288,571 220,073 Mean St. dev. -0.48 5.81 Panel A: Year 0.11 5.78 0.23 2.52 0.14 2.62 -0.19 3.09 0.22 2.75 -0.19 3.45 -1.58 9.34 Panel B: Grade -0.00 3.42 -1.22 8.15 Panel C: Coupon -0.26 6.06 -0.17 4.45 -0.37 5.49 -0.51 5.16 -0.97 7.07 Panel D: Years to Maturity -0.66 6.39 -0.46 5.11 -0.20 4.43 -0.39 6.59 -0.39 5.83 Panel E: Stock Return St. Dev. -0.06 3.24 -0.09 3.47 -0.30 4.41 -0.60 5.83 -1.87 10.84 25%ile -1.03 -1.60 -0.78 -0.67 -1.00 -0.48 -0.88 -2.38 -0.73 -1.90 -0.97 -0.69 -1.04 -1.09 -1.46 -0.69 -0.93 -1.02 -2.04 -1.86 -0.75 -0.83 -1.05 -1.42 -1.82 Median -0.01 -0.20 0.03 0.02 -0.13 0.12 -0.01 -0.14 0.03 -0.13 0.08 0.05 -0.03 -0.07 -0.11 -0.01 -0.03 0.02 0.04 -0.04 0.04 0.02 -0.00 -0.06 -0.14 75%ile 0.90 1.68 0.96 0.71 0.72 0.78 0.79 1.33 0.78 1.19 1.13 0.75 0.87 0.83 1.03 0.60 0.80 0.98 1.99 1.59 0.83 0.86 0.95 1.06 0.87

All bonds 2002 2003 2004 2005 2006 2007 2008 Investment Grade High-Yield Q1 Q2 Q3 Q4 Q5 Q1 Q2 Q3 Q4 Q5 Q1 Q2 Q3 Q4 Q5

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Table 3 Regression of Monthly Stock Returns on Lagged Monthly Bond and Stock Returns This table displays estimated coefficients from regressions of current monthly stock returns on lagged bond returns and lagged stock returns for 1,958 bond-stock pairs from July 2002 through December 2008. The dependent variable is the current monthly (4-week) stock returns. Prior Bond (Stock) Return is the abnormal bond (stock) return from the specified month. Negative Bond (Stock) Return? is an indicator variable that takes the value 1 if the abnormal bond (stock) return was negative over the specified month. Standard errors are clustered at the stock ticker (company) level since companies issue multiple bonds. T-statistics are in parentheses. Panel A: All Bonds -1-2-3Intercept -0.003** -0.003** 0.002 (2.14) (2.16) (1.42) Prior Bond Return (Month 1) 0.111*** 0.136*** -0.030 (2.86) (3.16) (0.45) Prior Bond Return (Month 1) * Negative Bond Return? 0.242*** (3.03) Prior Bond Return (Month 2) -0.065 -0.065 0.001 (1.16) (1.15) (0.02) Prior Bond Return (Month 2) * Negative Bond Return? -0.152 (1.51) Prior Bond Return (Month 3) -0.046 -0.092** -0.042 (1.02) (2.45) (0.58) Prior Bond Return (Month 3) * Negative Bond Return? -0.134 (1.27) Prior Stock Return (Month 1) -0.029 -0.032 (1.24) (1.24) Prior Stock Return (Month 1) * Negative Stock Return? 0.006 (0.11) Prior Stock Return (Month 2) -0.007 -0.018 (0.39) (0.85) Prior Stock Return (Month 2) * Negative Stock Return? 0.018 (0.40) Prior Stock Return (Month 3) 0.045* -0.041* (1.91) (1.77) Prior Stock Return (Month 3) * Negative Stock Return? 0.177*** (3.32) Observations 1,284,037 1,279,170 1,279,170 R2 0.0030 0.0051 0.0096 Panel B: High-Yield Bonds Prior Bond Return (Month 1) 0.200*** 0.226*** 0.177** (4.91) (4.46) (2.10) Prior Bond Return (Month 1) * Negative Bond Return? 0.044 (0.45) Observations 493,362 490,724 490,724 R2 0.0094 0.0110 0.0149 Panel C: Investment-Grade Bonds Prior Bond Return (Month 1) -0.133** -0.108** -0.296*** (2.19) (2.08) (2.82) Prior Bond Return (Month 1) * Negative Bond Return? 0.331** (2.30) Observations 790,675 788,446 788,446 R2 0.0048 0.0090 0.0151 ***, **, * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively

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Table 4 Regression Results One Bond (or Bond Portfolio) per Company This table displays estimated coefficients from regressions of current monthly stock returns on lagged bond returns and lagged stock returns for 658 bond-stock pairs from July 2002 through December 2008. Because companies issue multiple bonds, this table is designed to show samples where only one bond from each company is included. The first three columns include only a companys most liquid bond, measured three different ways (Trades/Day, % Days Traded, and Daily Volume). The fourth column displays results where the bond is an equally-weighted portfolio of the companys bonds. The dependent variable is the current monthly (4-week) stock returns. Prior Bond Return is the abnormal bond return from the specified month. Negative Bond Return? is an indicator variable that takes the value 1 if the abnormal bond return was negative over the specified month. Coefficients are from two specifications from Table 3. The other coefficients are omitted for brevity. T-statistics are in parentheses. Most Liquid Most Liquid Most Liquid Bond Bond Bond (Trades/ (% Days (Daily Portfolio of Panel A: All Grades Day) Traded) Volume) Bonds Model 2, Table 3 Prior Bond Return (Month 1) 0.169*** 0.158*** 0.165*** 0.163*** (37.08) (34.64) (36.84) (40.19) Model 3, Table 3 Prior Bond Return (Month 1) 0.022** 0.016* 0.011 0.027*** (2.37) (1.69) (1.19) (3.42) Prior Bond Return (Month 1) * Negative Bond Return? 0.225*** 0.214*** 0.235*** 0.211*** (17.86) (16.93) (19.02) (20.28) Observations 305,532 303,027 311,284 453,678 Panel B: High-Yield Bonds Model 2, Table 3 Prior Bond Return (Month 1) 0.182*** 0.176*** 0.188*** 0.187*** (30.49) (29.28) (31.67) (33.00) Model 3, Table 3 Prior Bond Return (Month 1) 0.060*** 0.049*** 0.063*** 0.095*** (4.69) (3.71) (4.95) (8.15) Prior Bond Return (Month 1) * Negative Bond Return? 0.183*** 0.191*** 0.186*** 0.142*** (10.99) (11.24) (11.21) (9.66) Observations 189,594 184,638 191,645 233,384 Panel C: Investment-Grade Bonds Model 2, Table 3 Prior Bond Return (Month 1) 0.050*** 0.028*** 0.036*** -0.012** (7.37) (4.28) (5.60) (2.09) Model 3, Table 3 Prior Bond Return (Month 1) -0.104*** -0.068*** -0.136*** -0.126*** (8.32) (5.59) (11.41) (12.23) Prior Bond Return (Month 1) * Negative Bond Return? 0.283*** 0.179*** 0.307*** 0.186*** (15.70) (10.19) (17.73) (12.54) Observations 115,938 118,659 119,639 227,773 ***, **, * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively

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Table 5 Regression Results by Time Period This table displays estimated coefficients from regressions of current monthly stock returns on lagged bond returns and lagged stock returns broken out by time periods from 2005-2008. The dependent variable is the current monthly (4-week) stock returns. Prior Bond Return is the abnormal bond return from the specified month. Negative Bond Return? is an indicator variable that takes the value 1 if the abnormal bond return was negative over the specified month. Standard errors are clustered at the stock ticker (company) level since companies issue multiple bonds. Coefficients are from two specifications from Table 3. All but the first bond lags are omitted for brevity. T-statistics are in parentheses. Panel A: All Grades 2005-2006 2007 2008 Model 2, Table 3 Prior Bond Return (Month 1) 0.096* 0.163** 0.141** (1.95) (2.25) (2.58) Model 3, Table 3 Prior Bond Return (Month 1) 0.056 0.168*** -0.119 (0.70) (2.68) (1.30) Prior Bond Return (Month 1) * Neg. Bond Return? 0.082 -0.015 0.371*** (0.74) (0.16) (3.46) Observations Panel B: High-Yield Bonds Model 2, Table 3 Prior Bond Return (Month 1) Model 3, Table 3 Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? Observations Panel C: Investment-Grade Bonds Model 2, Table 3 Prior Bond Return (Month 1) Model 3, Table 3 Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? 427,479 2005-2006 0.124* (1.95) 0.078 (0.77) 0.087 (0.64) 183,286 2005-2006 -0.027 (0.83) 0.013 (0.23) -0.074 (0.78) 303,171 2007 0.165* (1.76) 0.234*** (2.68) -0.109 (0.90) 128,388 2007 0.146** (2.14) 0.129 (1.42) 0.044 (0.39) 386,806 2008 0.247*** (3.72) 0.164 (1.28) 0.091 (0.66) 143,087 2008 -0.156** (2.39) -0.408*** (3.04) 0.438** (2.45) 243,719

Observations 244,193 174,783 ***, **, * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively

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Table 6 Regression Results by Prior Months Stock Movement This table displays estimated coefficients from regressions of current monthly stock returns on lagged bond returns, but excludes lagged stock returns. The equations are estimated separately, depending on the prior months stock movement (up or down). The dependent variable is the current monthly (4-week) stock returns. Prior Bond Return is the abnormal bond return from the specified month. Negative Bond Return? is an indicator variable that takes the value 1 if the abnormal bond return was negative over the specified month. Standard errors are clustered at the stock ticker (company) level since companies issue multiple bonds. Coefficients are from two specifications from Table 3, with prior stock returns omitted. Coefficients from longer bond lags are omitted for brevity. T-statistics are in parentheses. Panel A: All Grades Stock Down Last Month Stock Up Last Month Model A Prior Bond Return (Month 1) 0.145*** 0.035 (2.89) (1.06) Model B Prior Bond Return (Month 1) 0.167 -0.061 (1.20) (1.56) Prior Bond Return (Month 1) * Neg. Bond Return? -0.026 0.232** (0.16) (2.58) Observations Panel B: High-Yield Bonds Model A Prior Bond Return (Month 1) Model B Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? Observations Panel C: Investment-Grade Bonds Model A Prior Bond Return (Month 1) Model B Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? 695,932 Stock Down Last Month 0.204*** (3.86) 0.521** (2.35) -0.359 (1.48) 279,698 Stock Down Last Month -0.089 (0.99) -0.042 (0.36) -0.074 (0.39) 668,309 Stock Up Last Month 0.136*** (3.10) 0.041 (0.81) 0.216* (1.88) 244,714 Stock Up Last Month -0.110*** (3.22) -0.161*** (3.21) 0.136 (1.14) 423,595

Observations 416,234 ***, **, * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively

34

Table 7 Regression Results by Coupon Quartiles This table displays estimated coefficients from regressions of current monthly stock returns on lagged bond returns and lagged stock returns for 1,958 bond-stock pairs from July 2002 through December 2008 broken out by coupon quartiles, plus a set of zero-coupon bonds. The bottom two panels split the sample by grade. The dependent variable is the current monthly (4-week) stock returns. Prior Bond Return is the abnormal bond return from the specified month. Negative Bond Return? is an indicator variable that takes the value 1 if the abnormal bond return was negative over the specified month. Standard errors are clustered at the stock ticker (company) level since companies issue multiple bonds. Coefficients are from two specifications from Table 3. All but the first bond lags are omitted for brevity. Tstatistics are in parentheses. Panel A: All Bonds Zeroes Q1 Q2 Q3 Q4 Model 2, Table 3 Prior Bond Return (Month 1) 0.179** 0.063 -0.086 0.025 0.277*** (2.22) (1.54) (0.95) (0.62) (4.35) Model 3, Table 3 Prior Bond Return (Month 1) 0.023 -0.100 -0.086 -0.173** 0.178 (0.42) (1.37) (0.61) (2.32) (1.44) Prior Bond Return (Month 1) * Neg. Bond Return? 0.273** 0.268** 0.269* 0.278*** 0.115 (2.43) (2.04) (1.78) (2.78) (0.78) Observations Panel B: High-Yield Bonds Model 2, Table 3 Prior Bond Return (Month 1) Model 3, Table 3 Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? Observations Panel C: Investment-Grade Bonds Model 2, Table 3 Prior Bond Return (Month 1) Model 3, Table 3 Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? 31,948 Zeroes 0.292*** (3.94) 0.083 (0.98) 0.347** (2.41) 10,485 Zeroes 0.006 (0.05) 0.002 (0.03) 0.014 (0.09) 313,849 Q1 0.055 (1.04) -0.005 (0.06) 0.084 (0.77) 103,232 Q1 -0.084* (1.72) -0.385 (1.56) 0.545 (1.42) 287,971 Q2 0.202** (2.60) 0.231 (1.47) -0.111 (0.68) 121,857 Q2 -0.089 (0.76) -0.337** (2.40) 0.421 (1.54) 302,706 Q3 0.233*** (3.21) 0.046 (0.45) 0.219 (1.57) 134,294 Q3 -0.068 (1.06) -0.218* (1.88) 0.270 (1.64) 153,933 342,696 Q4 0.345*** (4.54) 0.388** (2.08) -0.064 (0.29) 120,856 Q4 -0.165*** (2.76) -0.281*** (3.21) 0.193 (1.53) 222,363

Observations 21,463 226,461 164,226 ***, **, * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively

35

Table 8 Regression Results by Years to Maturity Quintiles This table displays estimated coefficients from regressions of current monthly stock returns on lagged bond returns and lagged stock returns for 1,958 bond-stock pairs from July 2002 through December 2008 broken out by years to maturity quintiles. The bottom two panels split the sample by grade. The dependent variable is the current monthly (4week) stock returns. Prior Bond Return is the abnormal bond return from the specified month. Negative Bond Return? is an indicator variable that takes the value 1 if the abnormal bond return was negative over the specified month. Standard errors are clustered at the stock ticker (company) level since companies issue multiple bonds. Coefficients are from two specifications from Table 3. All but the first bond lags are omitted for brevity. T-statistics are in parentheses. Panel A: All Bonds Q1 Q2 Q3 Q4 Q5 Model 2, Table 3 Prior Bond Return (Month 1) 0.222*** 0.180*** 0.200*** 0.086 0.056 (2.75) (3.54) (2.92) (1.49) (1.63) Model 3, Table 3 Prior Bond Return (Month 1) 0.019 -0.001 0.131 -0.115** -0.129* (0.15) (0.01) (1.12) (2.11) (1.81) Prior Bond Return (Month 1) * Neg. Bond Return? 0.273** 0.227** 0.107 0.332*** 0.321** (2.15) (2.06) (0.80) (2.83) (2.51) Observations Panel B: High-Yield Bonds Model 2, Table 3 Prior Bond Return (Month 1) Model 3, Table 3 Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? Observations Panel C: Investment-Grade Bonds Model 2, Table 3 Prior Bond Return (Month 1) Model 3, Table 3 Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? 265,856 Q1 0.273*** (2.76) 0.243 (1.65) 0.001 (0.00) 100,440 Q1 -0.109 (0.97) -0.321* (1.69) 0.339 (1.45) 253,588 Q2 0.269*** (5.14) 0.238* (1.91) 0.009 (0.06) 102,077 Q2 -0.145* (1.76) -0.317** (2.47) 0.289 (1.53) 264,829 Q3 0.267*** (3.15) 0.306** (2.01) -0.065 (0.38) 98,943 Q3 -0.067 (1.07) -0.233* (1.94) 0.327 (1.31) 241,080 Q4 0.204*** (2.76) 0.118 (1.20) 0.112 (0.67) 91,209 Q4 -0.037 (0.56) -0.220*** (2.68) 0.342** (2.38) 150,478 253,230 Q5 0.154*** (3.71) 0.049 (0.97) 0.166* (1.75) 98,055 Q5 -0.112** (2.27) -0.310* (1.91) 0.367 (1.44) 153,591

Observations 164,830 152,701 166,846 ***, **, * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively

36

Table 9 Regression Results by Stock Volatility Quintiles This table displays estimated coefficients from regressions of current monthly stock returns on lagged bond returns and lagged stock returns for 1,958 bond-stock pairs from July 2002 through December 2008 broken out by quintiles sorted by the standard deviation of the stock . The bottom two panels split the sample by grade. The dependent variable is the current monthly (4-week) stock returns. Prior Bond Return is the abnormal bond return from the specified month. Negative Bond Return? is an indicator variable that takes the value 1 if the abnormal bond return was negative over the specified month. Standard errors are clustered at the stock ticker (company) level since companies issue multiple bonds. Coefficients are from two specifications from Table 3. All but the first bond lags are omitted for brevity. T-statistics are in parentheses. Panel A: All Bonds Q1 Q2 Q3 Q4 Q5 Model 2, Table 3 Prior Bond Return (Month 1) -0.070** -0.018 0.026 0.129 0.240*** (2.09) (0.39) (0.60) (1.51) (2.94) Model 3, Table 3 Prior Bond Return (Month 1) 0.018 0.016 -0.084 -0.029 0.024 (0.38) (0.33) (1.51) (0.20) (0.14) Prior Bond Return (Month 1) * Neg. Bond Return? -0.178 -0.065 0.190** 0.225 0.344* (1.62) (0.71) (2.11) (1.44) (1.67) Observations Panel B: High-Yield Bonds Model 2, Table 3 Prior Bond Return (Month 1) Model 3, Table 3 Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? Observations Panel C: Investment-Grade Bonds Model 2, Table 3 Prior Bond Return (Month 1) Model 3, Table 3 Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? 284,836 Q1 0.059 (1.59) 0.035 (0.79) 0.051 (0.51) 68,860 Q1 -0.140*** (3.03) -0.036 (0.51) -0.200 (1.09) 292,467 Q2 0.056 (1.18) 0.147** (2.24) -0.122 (1.21) 92,838 Q2 -0.105** (2.09) 0.024 (0.40) -0.255* (1.95) 256,793 Q3 0.292*** (4.74) 0.175* (1.99) 0.174 (1.30) 133,453 Q3 -0.050 (0.65) -0.061 (0.93) 0.024 (0.15) 254,878 Q4 0.121 (1.32) 0.163 (1.17) -0.029 (0.20) 93,325 Q4 -0.010 (1.08) -0.296* (1.98) 0.351** (2.23) 144,240 190,196 Q5 0.306*** (2.87) 0.194 (1.01) 0.111 (0.56) 102,428 Q5 -0.108 (0.97) -0.649** (2.22) 0.868** (2.30) 135,203

Observations 195,274 172,716 141,013 ***, **, * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively

37

Table 10 Regression Results by Measures of Bond Liquidity This table displays estimated coefficients from regressions of current monthly stock returns on lagged bond returns and lagged stock returns for 1,958 bond-stock pairs from July 2002 through December 2008 broken out by quintiles based on three different measures of the bonds liquidity. The first (Panel A) is average trades per day over the bonds life. The second (Panel B) is the percentage of days the bond trades. The third (Panel C) is the average daily volume over the bonds life. The dependent variable is the current monthly (4-week) stock returns. Prior Bond Return is the abnormal bond return from the specified month. Negative Bond Return? is an indicator variable that takes the value 1 if the abnormal bond return was negative over the specified month. Standard errors are clustered at the stock ticker (company) level since companies issue multiple bonds. Coefficients are from two specifications from Table 3. All but the first bond lags are omitted for brevity. T-statistics are in parentheses. Panel A: Trades per Day Quintiles Q1 Q2 Q3 Q4 Q5 Model 2, Table 3 Prior Bond Return (Month 1) 0.143*** 0.048 0.147** 0.188*** 0.161** (3.30) (0.97) (2.09) (3.66) (2.12) Model 3, Table 3 Prior Bond Return (Month 1) -0.020 -0.013 0.060 -0.066 -0.088 (0.32) (0.23) (0.53) (0.72) (0.99) Prior Bond Return (Month 1) * Neg. Bond Return? 0.245*** 0.079 0.120 0.364*** 0.392*** (2.99) (1.05) (0.91) (2.96) (2.92) Observations Panel B: Percentage of Days Traded Quintiles Model 2, Table 3 Prior Bond Return (Month 1) Model 3, Table 3 Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? Observations Panel C: Daily Volume Quintiles Model 2, Table 3 Prior Bond Return (Month 1) Model 3, Table 3 Prior Bond Return (Month 1) Prior Bond Return (Month 1) * Neg. Bond Return? 267,627 Q1 0.107*** (2.60) 0.006 (0.11) 0.138* (1.69) 258,098 Q1 0.132** (2.44) 0.016 (0.26) 0.162 (1.63) 254,657 Q2 0.110** (2.33) -0.066 (1.03) 0.270*** (3.01) 252,168 Q2 0.189*** (3.34) 0.048 (0.69) 0.197** (2.02) 266,263 Q3 0.200*** (2.90) 0.032 (0.24) 0.249 (1.44) 274,080 Q3 0.149** (2.27) 0.082 (0.90) 0.076 (0.78) 266,839 Q4 0.151** (2.20) -0.018 (0.20) 0.228** (2.02) 268,584 Q4 0.078 (1.34) -0.136 (1.21) 0.312** (2.20) 275,515 223,784 Q5 0.131 (1.52) -0.132 (1.36) 0.431*** (3.14) 226,240 Q5 0.070 (1.06) -0.229** (2.02) 0.500*** (2.97) 227,268

Observations 174,612 302,122 299,653 ***, **, * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively

38

2%

1%

0% -20% Abnormal Stock Return - Current Month -15% -10% -5% 0% 5% 10%

-1%

-2%

-3%

Figure 1 Trading Strategy All Bonds This figure displays the results of a trading strategy based on observing a companys abnormal bond returns for one month (twenty trading days) and then investing in that companys stock for one month. Deciles are formed based on the prior months abnormal bond returns, which are plotted on the x-axis. The current monthly abnormal stock return for each decile is plotted on the y-axis. Results are shown for all bond-stock pairs, and separately for highyield and investment grade bonds.

39

2.0% All High-Yield Bonds Most Liquid Bond - Trades Per Day Most Liquid Bond - % Days Traded Most Liquid Bond - Daily Volume Portfolio of Bonds

1.0%

-15.0%

-10.0%

-5.0%

0.0% 0.0%

5.0%

10.0%

-1.0%

-2.0%

-3.0%

Figure 2a Trading Strategy Most Liquid Bonds and Portfolio of All Bonds High-Yield Only This figure displays a trading strategy identical to Figure 1, but based only on a firms most liquid bond measured three different ways or on a portfolio of all of a firms bonds, confined to high-yield bonds. Figure 2b shows the same results for investment-grade bonds. The trading strategy is based on observing a companys abnormal bond returns for one month (twenty trading days) and then investing in that companys stock for one month. Within each type of bond or bond portfolio, deciles are formed based on the prior months abnormal bond or bond portfolio returns, which are plotted on the x-axis. The current monthly abnormal stock return for each decile is plotted on the y-axis.

40

2%

1%

0% -20% Abnormal Stock Return - Current Month -15% -10% -5% 0% 5% 10%

-1%

All Investment-Grade Bonds Most Liquid Bond - Trades Per Day Most Liquid Bond - % Days Traded Most Liquid Bond - Daily Volume Portfolio of Bonds

-2%

-3%

Figure 2b Trading Strategy Most Liquid Bonds and Portfolio of All Bonds Investment Grade Only

41

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