Correlation between equity returns and debt spread changes

Question

I have got two rather short questions.

Statement: Theoretically, a firm's equity prices and credit spreads should be negatively correlated. This correlation tends to be stronger for riskier companies.

My questions:

1. Is this statement correct?
2. Does this statement tell anything about the stock returns and the credit spread changes? In other words: Can I conclude that the correlation mentioned above also holds for stock returns (%) and spread changes (%)?

Thanks!

Answer 1

Answer to question 2:

This is the famous Merton's theorem. It says that returns from the stock mimics the fundamentals of the company, in other words, the credit risk of the company. We use it for modelling the market risk of a stock.

E.g. The translation Matrixx provides the probability of a company's debt to more from one state to other, say Aaa to B is 5%. Now, the theorem assumes that this probability of downgradation of debt also reflects in the returns of the stock. If one assumes that the returns are normally distributed, then the returns have to fall by (mean -1.645 *std dev) for the debt rating to move to B.