The Debt-Equity Spread

We propose the debt-equity spread (DES), the difference between the actual and equity-implied credit spreads, as a measure of the valuation gap between debt and equity at the firm and bond level. DES strongly predicts stock and bond returns in opposite directions. A strategy that takes a long position in firms with low DES (indicating that stocks are cheap relative to bonds) and a short position in those with high DES generates an average stock return of 7.72% and bond return of -4.97% per annum. The return predictability is consistently significant over subsamples and is stronger among smaller, less liquid, and more difficult-to-short stocks and bonds. In addition, firms with higher DES tend to have more negative revisions in long-term growth forecasts, issue equity and retire debt more aggressively, and their insiders are more likely to sell their stocks. Together, these findings support DES being a measure of relative mispricing between debt and equity