We show that firm default risk is the primary predictor of the correlation between corporate bond and stock returns, both in the cross-section and over time. Bonds of less creditworthy firms behave more like the issuing firms’ stocks, resulting in higher future comovement. As a direct implication, investing in bonds and stocks of the most creditworthy firms significantly enhances diversification benefits and Sharpe ratios out-of-sample. We develop a structural model with stochastic asset variance that rationalizes these findings, whereby time-variation in asset variance plays a critical role for breaking down the perfect stock-bond correlation implied by the Merton model.

We examine the role of institutional investors in monetary policy transmission to asset markets by exploiting a discontinuous threshold in the tax treatment of municipal bonds. As bonds approach the threshold, mutual funds, the primary institutional traders in the market, dispose of the bonds at significant risk of falling below the threshold. This is driven by mutual funds anticipating future illiquidity. Once bonds cross the threshold, their liquidity declines and illiquidity-induced yield spreads increase substantially as retail investors become more important in price formation. Unexpected monetary policy tightening sharply reduces trading activity, amplifying the path to illiquidity in the market.

We investigate the scope for active investing in corporate bonds by estimating an optimal portfolio using asset characteristics. Our portfolio weights are modeled to account for the severe trading frictions present in OTC bond markets. A portfolio based on maturity, rating, coupon, and size outperforms passive benchmarks and univariate sorts after transaction costs in and out of sample. Further, it predicts macroeconomic activity, suggesting bond characteristics provide hedging against macro-fluctuations. Active funds appear constrained by narrow investment mandates from holding the optimal portfolio. Overall, while active corporate bond portfolios are feasible, institutional constraints might limit their accessibility.