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.
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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