The Debt-Equity Spread

82 Pages Posted: 25 Oct 2021 Last revised: 8 Nov 2022

See all articles by Hui Chen

Hui Chen

Massachusetts Institute of Technology

Zhiyao Chen

Lingnan University - Department of Finance and Insurance

Jun Li

University of Texas at Dallas

Date Written: May 30, 2022

Abstract

We propose a new measure of the valuation gap between debt and equity, the debt-equity spread (DES), based on the difference between actual and equity-implied credit spreads. A long-short strategy based on DES generates an annual premium of 7.72% and -4.97% for stocks and bonds, respectively, with stronger results among smaller, less liquid, and more difficult-to-short stocks and bonds. High-DES firms tend to have more negative growth forecast revisions, are more likely to issue equity and retire debt, and have more insider equity selling. Together, these findings support DES as a measure of the relative mispricing between debt and equity.

Keywords: credit risk, market integration, stock and bond return predictions, mispricing

JEL Classification: G13, G31, G32, G33

Suggested Citation

Chen, Hui and Chen, Zhiyao and Li, Jun, The Debt-Equity Spread (May 30, 2022). Available at SSRN: https://ssrn.com/abstract=3944082 or http://dx.doi.org/10.2139/ssrn.3944082

Hui Chen

Massachusetts Institute of Technology ( email )

50 Memorial Drive
Cambridge, MA 02142
United States
+1 (617) 324-3896 (Phone)

Zhiyao Chen (Contact Author)

Lingnan University - Department of Finance and Insurance ( email )

8 Castle Peak Rd
Tuen Mun
Hong Kong

Jun Li

University of Texas at Dallas ( email )

800 West Campbell Road, SM 31
Richardson, TX 75080
United States
972-883-4422 (Phone)

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