Mean Reversion in Asset Returns with Varying Debt and Equity Components: Evidence and Implications from Preferred Stock

Abstract

This study documents the existence of mean reversion in three classes of preferred stock and high grade corporate bond returns. The lack of mean reversion in high grade preferred stock returns is consistent with the argument that high grade preferred stock resembles high grade corporate bonds which do not exhibit mean reverting behavior in returns. However, returns to both medium and speculative (GRADE) preferred stock exhibit mean reverting behavior during the pre-war period that intensifies as credit quality declines. We conclude, therefore, that a common force drives the mean reversion of returns found in common equity, medium and speculative grade preferred stock. This same force, however, does not appear to impact the return generating process of high grade preferred stock or corporate bonds.

JEL Classification: G12, G14, G35