Debt-Equity Spread in Bonds
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Hui Chen; Zhiyao Chen; Jun Li
- Massachusetts Institute of Technology
- National Bureau of Economic Research
- ?National Bureau of Economic Research (NBER)
- Chinese University of Hong Kong
- ?The Chinese University of Hong Kong (CUHK) - Department of Finance
- ?University of Texas at Dallas
Strategy in a nutshell
This strategy trades corporate bonds of non-financial firms listed on NYSE, AMEX, and NASDAQ. Using CRSP and Compustat for equity and accounting data, and Lehman Brothers Fixed Income Database, NAIC, and WRDS for bond data, the debt-equity spread is calculated as the difference between the actual credit spread and the equity-implied credit spread. The latter is derived from theoretical bond prices and matched Treasury yields. Each month, bonds are sorted into quintiles by their firm’s debt-equity spread. The portfolio goes long the highest quintile and short the lowest, with monthly rebalancing and value-weighted positions.
Economic rationale
The debt-equity spread identifies relative mispricing between bonds and equities. A high spread signals overvalued equity and undervalued bonds, while a low spread indicates the opposite. This anomaly persists as firms and insiders exploit mispricing via equity issuance and debt retirement, and executives tend to sell overvalued stock. The effect is robust to standard risk factors, firm characteristics, and demonstrates systematic, persistent mispricing exploitable through this strategy.