The Term Structure of Credit Spreads and the Cross-Section of Stock Returns
49 Pages Posted: 6 Feb 2015 Last revised: 27 Apr 2016
Date Written: February 22, 2015
Abstract
We explore the link between credit and equity markets by considering the informational content of the term structure of credit spreads. A shallower credit term structure predicts decreases in default risk, increases in future profitability, as well as favorable earnings surprises. Further, the slope of the credit term structure negatively predicts future stock returns. While systematic slope risk is also priced, information diffusion from the credit market to equities, particularly in less visible stocks, plays an additional role in accounting for return predictability from credit slopes: Such predictability is less evident in stocks with high institutional ownership, analyst coverage, and liquidity, and vice versa.
Keywords: cross-section of stock return, credit spreads, term structure, slow information diffusion, limited attention, default risk premium
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