The Debt-Equity Spread

We propose the debt-equity spread (DES) as a measure of the valuation gap between debt and equity at firm level. DES strongly predicts stock and bond returns in opposite directions. A strategy that takes long positions in firms with low DES, whose stocks are cheap relative to bonds, and short those with high DES generates an average stock return of 6% per annum and bond return of -3.3% per annum. The return predictability is consistently stronger among small, illiquid, and difficult-to-short stocks and bonds. In addition, higher debt-equity spreads are associated with (i) higher probability for negative revision of long-term earnings growth forecasts; (ii) more equity issuance and debt repurchase, resulting in a low leverage ratio; (iii) stronger preferences for stock payments in acquisitions; and (iv) more insider stock selling. Together, these results suggest that the return prediction of DES is likely driven by mispricing rather than risk exposures.