Dissecting the bond profitability premium

In contrast to prior equity market results, we document that corporate bonds issued by low profitability firms outperform bonds issued by highly profitable firms. This performance difference is primarily driven by low profitability, low credit rating firms. This profitability premium is consistent w...

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Bibliographic Details
Published in:Journal of financial markets (Amsterdam, Netherlands) Netherlands), 2016-01, Vol.27, p.102-131
Main Authors: Campbell, T. Colin, Chichernea, Doina C., Petkevich, Alex
Format: Article
Language:English
Subjects:
Bonds
Credit risk
Discount rates
Equity
Profitability
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Summary:In contrast to prior equity market results, we document that corporate bonds issued by low profitability firms outperform bonds issued by highly profitable firms. This performance difference is primarily driven by low profitability, low credit rating firms. This profitability premium is consistent with compensation for default risk and can be explained by default risk factors that include speculative-grade bonds. The impact of profitability on equity returns depends on the relative importance of default risk and the risk of the firm׳s investments when solvent, consistent with higher profitability signaling both lower future distress and riskier investments resulting in higher discount rates. •We analyze the impact of firm profitability on bond returns.•Our results suggest that the bonds of more profitable firms tend to underperform.•We show higher performance of low profitability firms compensates for default risk.•Default factors that include high-risk firms more effectively capture default risk.•In the equity market, profitability incorporates both upside and downside risks.
ISSN:1386-4181
1878-576X
DOI:10.1016/j.finmar.2015.11.002