The Debt-Equity Spread
69 Pages Posted: 25 Oct 2021 Last revised: 15 Dec 2021
Date Written: October 17, 2021
We propose the debt-equity spread (DES), the difference between the actual and equity-implied credit spreads, as a measure of the valuation gap between debt and equity at the firm and bond level. DES strongly predicts stock and bond returns in opposite directions. A strategy that takes a long position in firms with low DES (indicating that stocks are cheap relative to bonds) and a short position in those with high DES generates an average stock return of 6.31% and bond return of -5.53% per annum. The return predictability is consistently significant over subsamples and is stronger among smaller, less liquid, and more difficult-to-short stocks and bonds. In addition, firms with higher DES tend to have more negative revisions in long-term growth forecasts, issue equity and retire debt more aggressively, and have more insiders selling their stocks. Together, these findings support DES being a measure of 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: Suggested Citation