Industry Competition, Credit Spreads, and Levered Equity Returns
56 Pages Posted: 8 Jun 2017
Date Written: June 1, 2017
This paper examines the relation between industry competition, credit spreads, and levered equity returns. I build a quantitative model where firms make investment, financing, and default decisions subject to aggregate and idiosyncratic risk. Firms operate in heterogeneous industries that differ by the intensity of product market competition. Higher competition reduces profit opportunities and increases default risk for debtholders. Equityholders are protected against default risk due to the option value arising from limited liability. In equilibrium, competitive industries are characterized by higher credit spreads, but lower expected equity returns. I find strong empirical support for these predictions across concentration terciles.
Keywords: Strategic interactions, Capital structure, Default, Corporate bond credit spread, Equity premium, Recursive preferences
JEL Classification: G11, G12, G32, G33, E23, E32
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