The Debt-Equity Spread

69 Pages Posted: 25 Oct 2021 Last revised: 15 Dec 2021

See all articles by Hui Chen

Hui Chen

Massachusetts Institute of Technology; National Bureau of Economic Research (NBER)

Zhiyao Chen

The Chinese University of Hong Kong (CUHK) - Department of Finance

Jun Li

University of Texas at Dallas

Date Written: October 17, 2021

Abstract

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

Chen, Hui and Chen, Zhiyao and Li, Jun, The Debt-Equity Spread (October 17, 2021). 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
617-324-3896 (Phone)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Zhiyao Chen (Contact Author)

The Chinese University of Hong Kong (CUHK) - Department of Finance ( email )

Shatin, N.T.
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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