The Debt-Equity Spread

Abstract

We propose a measure of valuation gap between debt and equity, the debt-equity spread (DES), based on the difference between actual and equity-implied credit spreads. DES predicts the cross section of stock and bond returns in opposite directions, with stronger results among smaller, less liquid, and more difficult-to-short stocks and bonds, and the predictability cannot be explained by exposures to a variety of risk factors. Furthermore, 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. These findings on asset pricing dynamics and corporate financing behavior are consistent with DES capturing relative mispricing between debt and equity. They imply that segmentation between the two markets is prevalent at firm level.

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

JEL Classification: G13, G31, G32, G33