Debt-Equity Spread in Equities
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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
The strategy targets common stocks listed on NYSE, AMEX, and NASDAQ, excluding financial firms. Stock and accounting data are obtained from CRSP and Compustat, with bond returns from Lehman Brothers Fixed Income Database, NAIC, and WRDS. Using the zero-coupon yield curve from FRED, the strategy calculates the debt-equity spread as the difference between the actual credit spread and the equity-implied credit spread. Stocks are sorted monthly into quintiles based on their debt-equity spread, going long on the bottom quintile (low spread) and short on the top quintile (high spread). Portfolios are value-weighted and rebalanced monthly.
Economic rationale
The debt-equity spread identifies mispricing between equity and bonds by capturing valuation gaps. A high spread indicates overvalued equity and undervalued bonds, while a low spread indicates the opposite. The anomaly persists despite standard risk factors, firm characteristics, or security traits, as corporate actions and insider behaviors often exploit these mispricings. Executives tend to sell high spread stocks more frequently, highlighting the strategy’s ability to systematically capitalize on persistent misvaluation in both equity and bond markets.