Net leverage, risk, and credit spreads

Berardino Palazzo

No 436, 2013 Meeting Papers from Society for Economic Dynamics

Abstract: This paper proposes a risk-based explanation of the negative relation between credit spreads and expected equity returns found in the data. In a model where issuing equity is costly and debt has a tax advantage, firms optimally choose a lower net leverage if their cash flows are more correlated to a source of aggregate fluctuations (i.e. if the firm is riskier), all else being equal. The model predicts that riskier firms have a lower net leverage and a lower credit spreads. I test these two predictions using data on U.S. public companies and I find that: (i) low net leverage firms earn a higher risk-adjusted return than high net leverage ones; (ii) risk-adjusted returns on net leverage sorted portfolios are negatively correlated to credit ratings (a proxy for credit spreads); and (iii) a net leverage-based factor has the potential to explain the variation in equity returns across portfolios sorted according to credit ratings.

Date: 2013
New Economics Papers: this item is included in nep-ban
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