Bonds, Stocks, and Sources of Mispricing

Abstract

Market-wide sentiment and firm-level financial distress jointly drive asset overpricing. The intersection of high sentiment and financial distress characterizes episodes of inflated bond and stock prices, to the extent that these securities are correctly priced otherwise. Overvaluation is attributable to sentiment-driven investors, both retail and institutional, who underestimate the severe implications of financial distress for a firm's future prospects. Anomalous patterns in the cross-section of stock and bond returns emerge as overpricing is corrected.

Keywords: sentiment, mispricing, anomalies, bonds, stocks, financial distress

JEL Classification: G12, G14