A New Test for an Old Puzzle

42 Pages Posted: 10 Jan 2024

See all articles by Lorenzo Bretscher

Lorenzo Bretscher

Swiss Finance Institute - HEC Lausanne; Centre for Economic Policy Research (CEPR)

Peter Feldhütter

Copenhagen Business School

Andrew Kane

Fuqua School of Business, Duke University

Lukas Schmid

University of Southern California - Marshall School of Business

Date Written: December 17, 2023

Abstract

Traditional tests of the credit spread puzzle are imprecise. We show that a key input of these tests, the equity Sharpe ratio, is difficult to estimate in available empirical samples. Instead, we show that the difference between the Sharpe ratios of debt returns and equity returns provides a more precise test. Using the new test we find no evidence for a credit spread puzzle in the corporate bond market: after controlling for the unexpected decline in interest rates beginning in the 1990s, the Sharpe ratios of equity and bonds of high quality firms are nearly identical. However, we uncover a new puzzle in the market for bank debt: loan returns have higher Sharpe ratios than equity returns.

Keywords: credit spread puzzle, credit risk, corporate debt, bond pricing, loan pricing

Suggested Citation

Bretscher, Lorenzo and Feldhütter, Peter and Kane, Andrew and Schmid, Lukas, A New Test for an Old Puzzle (December 17, 2023). Available at SSRN: https://ssrn.com/abstract=4667213 or http://dx.doi.org/10.2139/ssrn.4667213

Lorenzo Bretscher

Swiss Finance Institute - HEC Lausanne ( email )

Chavannes-près-Renens, Vaud
Switzerland
1015 (Fax)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Peter Feldhütter

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Andrew Kane (Contact Author)

Fuqua School of Business, Duke University ( email )

Durham, NC 27708-0120
United States

HOME PAGE: http://https://www.andrewbkane.com/

Lukas Schmid

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd, HOH 431
Los Angeles, CA California 90089-1424
United States

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