Daily Academic Alpha: Credit Spreads and Stock Returns

Daily Academic Alpha: Credit Spreads and Stock Returns

May 5, 2015 $IEF

Last updated on January 18th, 2017 at 02:38 pm

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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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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. 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.