Bonds, Stocks, and Sources of Mispricing

This paper shows that distressed stocks and bonds are overpriced during high sentiment periods. The correction of overpricing leads to a range of anomalous cross-sectional patterns in stock and bond returns. Including bonds as additional test assets allows us to develop testable restrictions about overpricing rationales related to lottery-type preferences, shareholders' ability to extract value during bankruptcy, and market sentiment. It also reinforces the notion that anomaly payoffs are unexplained by co-movement with risk factors. The evidence suggests that anomalies are attributable to sentiment-driven investors' (both retail and institutional) excessive optimism about the likelihood and consequences of financial distress.