Daily Academic Alpha: Credit Spreads and Stock Returns

Daily Academic Alpha: Credit Spreads and Stock Returns

May 5, 2015 $IEF
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(Last Updated On: January 18, 2017)

The Term Structure of Credit Spreads and the Cross-Section of Stock Returns

We explore the link between credit and equity markets by considering the informational content of the term structure of credit spreads. A shallower credit term structure predicts decreases in default risk, increases in future profitability, as well as favorable earnings surprises, and vice versa. Further, the slope of the credit term structure negatively predicts future stock returns, and this result does not arise from a premium for default risk. Rather, limited attention and arbitrage costs play important roles: return predictability from the credit spread slope holds mainly for stocks with low institutional ownership, analyst coverage, and stock liquidity.

The Cross-Section of Credit Risk Premia and Equity Returns

We explore the link between a firm’s stock returns and its credit risk using a simple insight from structural models following Merton (1974): risk premia on equity and credit instruments are related because all claims on assets must earn the same compensation per unit of risk. Consistent with theory, we find that firms’ stock returns increase with credit risk premia estimated from CDS spreads. Credit risk premia contain information not captured by physical or by risk-neutral default probabilities alone. This sheds new light on the “distress puzzle”, i.e. the lack of a positive relation between equity returns and default probabilities reported in previous studies.

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Definitions of common statistics used in our analysis are available here (towards the bottom)

About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.

  • Ben

    Hi Wes,

    This made me think of Hussman’s approach of mixing both valuations and the market’s risk appetite (which he hints often is driven by credit spreads). Are you looking into combining those signals to try and go after your “Tactical Asset Allocation with Market Valuations” approach – the winner might actually be TAA with Market Valuations AND credit spreads movement or something along those lines?