When Diversification Fades: a Firm Level Perspective of Stock and Corporate Bond Correlations

This paper examines the evolving relationship between corporate bond and stock returns in the euro area from 2007 to 2025. While theory predicts negative (or at least lower) correlations during periods of market stress and negative demand shocks, empirical evidence shows substantial instability over time. We construct equity and corporate bond indices using a strictly matched issuer universe, such that the constituent firms are identical across the two indices. We then analyse their correlation dynamics across major euro area markets using Dynamic Conditional Correlation models. Results indicate that correlations, historically negative, have since 2009 gradually trended toward neutrality, but can shift in either direction rapidly. We show that the discount-rate channel emerges as the dominant driver of co-movement in both low- and high-inflation environments. By contrast, financial stress reduces correlations – consistent with flight-to-quality dynamics –only in low-inflation regimes but not in high inflation regimes. This indicates that investors cannot rely on policy-induced compression in discount rates to generate cross-asset arbitrage opportunities in favour of bonds when inflation is high.