Off-Balance-Sheet Assets, Financial Leverage, and Stock Returns

Abstract

This paper examines the cross-sectional relationship between leverage and expected stock returns. While existing research documents a puzzling non-positive correlation, we show that this is largely driven by firms’ increased reliance on equity financing when they hold significant investments in off-balance-sheet assets. Because firms with riskier off-balance-sheet maintain lower leverage, a  negative relationship emerges between leverage and expected returns. This phenomenon is most pronounced among low-leverage firms—particular those with negative net debt —resulting in an overall check-mark-shaped relationship between market leverage and future stock returns.

Keywords: Leverage, Off-Balance-Sheet Assets, Investments, Conservative Accounting, Financial Assets, Stock Returns.

JEL Classification: M41, G12, G32, H26