Credit Indicators as Predictors of Economic Activity: A Real‐Time VAR Analysis

Using readily available indicators of the profitability, price, and availability of credit—the term spread, junk‐bond spread, and banks’ “willingness to lend” as reported by the Federal Reserve—we show that it is possible to significantly improve on the real‐time output and employment predictions of forecasting professionals at the medium‐run horizons that are most relevant to policymakers and private decision makers. Key to this improvement is a flexible state–space model of data revisions. The willingness‐to‐lend variable is the best real‐time predictor of GDP growth. For forecasting job growth, all three credit indicators prove helpful.     

The Decision to Repurchase Debt

The authors examined the market reaction to announcements of 208 corporate offers to repurchase outstanding debt during the period 1989–1996. In most tender offers, debtholders receive either a fixed price or a fixed spread over a benchmark Treasury security, or a range of prices based on a Dutch Auction. In most cases, management cites as its main motive the desire to reduce leverage and/or interest expense. But such tender offers are also often—in fact, in 70% of cases—accompanied by consent payments intended to induce bondholders to vote to remove covenant restrictions. The authors found that tender offers are wealth‐increasing events, with positive average market reactions of almost 1.5%. But the means of funding has a major impact on the market reaction. Whereas tender offers financed with equity receive a neutral market response, those offers financed with the proceeds from asset sales are associated with equity announcement returns of 3.8%. What's more, shareholders respond positively to the removal of covenants, especially asset sale covenants, with abnormal returns averaging 11% in such cases. Before their offers, companies that tender for their debt tend to have less cash and more long‐term debt than comparable companies, and to have lower operating returns and to trade at a discount to their peers. But after the tender offer, assets increase, operating returns improve, and the tendering firms trade at a premium.     

Consumption, Aggregate Wealth, and Expected Stock Returns

This paper studies the role of fluctuations in the aggregate consumption–wealth ratio for predicting stock returns. Using U.S. quarterly stock market data, we find that these fluctuations in the consumption–wealth ratio are strong predictors of both real stock returns and excess returns over a Treasury bill rate. We also find that this variable is a better forecaster of future returns at short and intermediate horizons than is the dividend yield, the dividend payout ratio, and several other popular forecasting variables. Why should the consumption–wealth ratio forecast asset returns? We show that a wide class of optimal models of consumer behavior imply that the log consumption–aggregate wealth (human capital plus asset holdings) ratio summarizes expected returns on aggregate wealth, or the market portfolio. Although this ratio is not observable, we provide assumptions under which its important predictive components for future asset returns may be expressed in terms of observable variables, namely in terms of consumption, asset holdings and labor income. The framework implies that these variables are cointegrated, and that deviations from this shared trend summarize agents' expectations of future returns on the market portfolio.     

The affect heuristic and stock ownership: A theoretical perspective

We consider asset prices and informational efficiency in a setting where owning stock confers direct utility due to an affect heuristic. Specifically, holding equity in brand name companies or those indulging in “socially desirable” activities (e.g., environmental consciousness) confers positive consumption benefits, whereas investing in “sin stocks” yields the reverse. In contrast to settings based on wealth considerations alone, expected stock prices deviate from expected fundamentals even when assets are in zero net supply. Stocks that yield high direct utility are, on average, more informationally efficient as they stimulate more entry into the market for these stocks and, consequently, more information collection. The analysis also accords with a value effect, high valuations of brand‐name stocks, abnormally positive returns on “sin stocks,” volume premia in the cross‐section of returns, proliferation of mutual funds and ETFs, and yields untested implications. If, as psychological literature suggests, agents derive greater utility from successful companies by “basking in reflected glory,” then asset prices react to public signals non‐linearly, leading to booms and busts, as well as crashes and recoveries.     

Downside Risk in Practice

Although investors associate risk with negative outcomes and downside fluctuations, modern portfolio theory does not. For investors, volatility per se is not necessarily bad; volatility below a benchmark is. A stock that magnifies the market's fluctuations is not necessarily bad; one that magnifies the market's downside swings is. Even Harry Mar‐kowitz, the father of modern portfolio theory, viewed downside risk as a better way to assess risk than the “mean‐variance” framework that he ultimately proposed and that has since become the standard. This article highlights the shortcomings of traditional measures of risk (the standard deviation and beta), introduces the concept of downside risk, and discusses two measures of it—the “semideviation” and “downside beta.” It also discusses the use of such measures in asset pricing models to estimate required returns on equity. Data from a few well‐known companies are used to illustrate that the cost of equity based on downside risk can be substantially different from that based on the CAPM. The article concludes with a brief discussion of risk‐adjusted returns and a comparison of the traditional method of calculating such returns with both the Sharpe ratio and its counterpart in a downside risk framework, the Sortino ratio. The appendix demonstrates how to calculate these risk measures in Excel.     

The flight‐to‐quality effect: a copula‐based analysis

We derive and estimate a copula combining the features of the Frank and Gumbel copulas to analyse the relationship between equity and long‐term bond returns. Our analysis of quarterly returns from 1952 to 2003 finds that, in general, there is a positive relationship between equity returns and bond returns. In extreme situations, however, there is approximately a one‐in‐seven chance of a flight‐to‐quality effect where large negative equity returns are associated with large positive bond returns.     

Time Variation in the Covariance between Stock Returns and Consumption Growth

The conditional covariance between aggregate stock returns and aggregate consumption growth varies substantially over time. When stock market wealth is high relative to consumption, both the conditional covariance and correlation are high. This pattern is consistent with the “composition effect,” where agents' consumption growth is more closely tied to stock returns when stock wealth is a larger share of total wealth. This variation can be used to test asset‐pricing models in which the price of consumption risk varies. After accounting for variations in this price, the relation between expected excess stock returns and the conditional covariance is negative.     

Valuation Risk and Asset Pricing

Standard representative‐agent models fail to account for the weak correlation between stock returns and measurable fundamentals, such as consumption and output growth. This failing, which underlies virtually all modern asset pricing puzzles, arises because these models load all uncertainty onto the supply side of the economy. We propose a simple theory of asset pricing in which demand shocks play a central role. These shocks give rise to valuation risk that allows the model to account for key asset pricing moments, such as the equity premium, the bond term premium, and the weak correlation between stock returns and fundamentals.     

The Impact of Sovereign Wealth Funds on Corporate Value and Performance

The last few years have seen a remarkable increase in the participation of sovereign wealth funds (SWFs) in global capital markets. In this article, the author draws on a unique dataset of SWF international holdings—one that dates back to the year 2002 and includes individual SWF holdings in more than 8,000 companies in 58 countries—to provide evidence of the impact of SWFs on corporate values and operating performance. Contrary to claims that SWFs expropriate minority investors and pursue political agendas, the main finding of the author's study is that SWF ownership is associated with positive changes in both corporate market values and operating returns. In support of these findings, the author also identifies three important ways that SWFs work to increase the performance and value of the companies they invest in: (1) as long‐term holders that provide a stable source of financing; (2) as representatives of deep pools of international capital in search of global diversification opportunities that are likely to provide companies with a lower‐cost (as well as more “patient”) source of equity capital; and (3) as politically well‐connected strategic investors that enable their companies to leverage important connections when accessing new product markets.     

Stock‐bond return co‐movement and accounting information

I examine how an important attribute of financial reporting quality, i.e., accounting conservatism, affects the sensitivity of corporate bond returns to changes in the value of equity (i.e., the hedge ratio). The correlation between stock and bond returns (co‐movement) is a fundamental input for asset allocation decisions as it determines the diversification benefits of bonds relative to equities within an investment portfolio. According to structural models of credit risk, co‐movement should be generally positive, but lower when the risk of wealth transfers from bondholders to shareholders is severe. I find that firms that report conservative earnings and use covenants in their bond contracts exhibit on average stronger co‐movement. This result is consistent with conservatism providing bondholders with a credible and contractible signal that improves monitoring, thus preventing wealth transfers.     

Deep Habits,Price Rigidities,and the Consumption Response to Government Spending

This paper studies two frictions, good‐specific habit formation and price rigidities, used in theoretical models to generate the crowding‐in of consumption by expansionary government spending observed in the data. Both frictions generate countercyclical price markups, rising wages, and ensuing consumption–leisure substitution to overcome the negative wealth effect of the fiscal expansion. I demonstrate that while they independently support the rise of consumption, when used together the two frictions exert opposing pressures on the markup and the wage, weakening consumption–leisure substitution. Crucially, when price stickiness is high enough in an economy with “deep” habits, consumption is crowded out by the fiscal expansion.     

Housing Collateral, Consumption Insurance, and Risk Premia: An Empirical Perspective

In a model with housing collateral, the ratio of housing wealth to human wealth shifts the conditional distribution of asset prices and consumption growth. A decrease in house prices reduces the collateral value of housing, increases household exposure to idiosyncratic risk, and increases the conditional market price of risk. Using aggregate data for the United States, we find that a decrease in the ratio of housing wealth to human wealth predicts higher returns on stocks. Conditional on this ratio, the covariance of returns with aggregate risk factors explains 80% of the cross‐sectional variation in annual size and book‐to‐market portfolio returns.     

The Cross‐Section of Credit Risk Premia and Equity Returns

We explore the link between a firm's stock returns and credit risk using a simple insight from structural models following Merton ( 1974 ): risk premia on equity and credit instruments are related because all claims on assets must earn the same compensation per unit of risk. Consistent with theory, we find that firms' stock returns increase with credit risk premia estimated from CDS spreads. Credit risk premia contain information not captured by physical or risk‐neutral default probabilities alone. This sheds new light on the “distress puzzle”—the lack of a positive relation between equity returns and default probabilities—reported in previous studies.     

Re‐equitizing Corporate Balance Sheets: Choosing Among the Alternatives

Companies are generally reluctant to issue new equity because it can be expensive capital. Among the largest costs of an equity offering are so‐called “market‐impact” costs. To the extent the typically negative market reaction to a stock offering causes an issue to be underpriced, such underpricing dilutes the value of current shareholders. Despite such costs, many companies—particularly financial institutions—are raising equity capital to “delever” balance sheets that have been squeezed by the credit crunch and economic slowdown. And far from transferring value from existing shareholders, these offerings can preserve and even increase the value of highly leveraged companies by shoring up their capital bases and providing the flexibility to get through a difficult period. According to recent studies, announcements of equity offerings by distressed companies have been accompanied by positive stock returns in excess of 5 %. The challenge for CFOs is to determine why and when issuing equity is the value‐maximizing strategy. The kinds of companies that are most likely to benefit from equity offerings are those that score low on credit metrics, have experienced cyclical declines in operating performance, and have growth opportunities as part of their recovery. There are a number of options for raising equity capital, but no set rules for identifying the optimal one. Nevertheless, the author offers a number of suggestions designed to help CFOs make smarter decisions: Communicate clearly to investors the intended uses of the proceeds from the equity offering and how they are expected to create value; Consider judicious cuts to the dividend to preserve capital; Involve current shareholders to minimize dilution, perhaps by considering a rights offering, and strengthen their commitment; Seek out “smart money” such as private equity or SWFs as long‐term investors; Get the offer size right the first time so a second offering can be avoided; and Monetize volatility in uncertain markets by issuing convertible securities.     

Market Reactions to Tangible and Intangible Information

The book‐to‐market effect is often interpreted as evidence of high expected returns on stocks of “distressed” firms with poor past performance. We dispute this interpretation. We find that while a stock's future return is unrelated to the firm's past accounting‐based performance, it is strongly negatively related to the “intangible” return, the component of its past return that is orthogonal to the firm's past performance. Indeed, the book‐to‐market ratio forecasts returns because it is a good proxy for the intangible return. Also, a composite equity issuance measure, which is related to intangible returns, independently forecasts returns.     

EQT: Private Equity with a Purpose

The primary factors driving the remarkable growth of private equity have been the industry's attractive and stable returns in combination with its active ownership model. Nevertheless, critics have been questioning whether the PE industry can maintain its historic returns, and challenging its fee and incentive structures as well as its notable lack of transparency and diversity. And the alleged systemic effects of the industry on social problems like income inequality and climate change have become large enough to create a perceived threat to PE's long‐term “license to operate.” In this article, the authors discuss the commitment of EQT, the publicly listed and Stockholm‐headquartered private markets firm (and eighth largest PE fundraiser in the world), to the “future‐proofing” of both its portfolio companies and the company itself. The company envisions itself as undertaking a “journey” toward sustainability and positive impact and, in so doing, furnishing a model that other PE firms might find useful in helping “future‐proof” the entire industry. As part of that commitment, EQT recently published a “Statement of Purpose” signed by its the board of directors that focuses a societal impact lens on its entire portfolio of companies and assets, reinforces its public commitments to diversity and other “clean and conscious” practices, and aims to leverage digital technologies to enhance financial returns and real‐world outcomes. Transparency and a mindset focused on achieving positive impact are the keys to PE's earning high and stable returns and to securing its long‐term license to operate.     

Stock and bond returns with Moody Investors

We present a tractable, linear model for the simultaneous pricing of stock and bond returns that incorporates stochastic risk aversion. In this model, analytic solutions for endogenous stock and bond prices and returns are readily calculated. After estimating the parameters of the model by the general method of moments, we investigate a series of classic puzzles of the empirical asset pricing literature. In particular, our model is shown to jointly accommodate the mean and volatility of equity and long term bond risk premia as well as salient features of the nominal short rate, the dividend yield, and the term spread. Also, the model matches the evidence for predictability of excess stock and bond returns. However, the stock–bond return correlation implied by the model is somewhat higher than that in the data.     

Opaque Financial Contracting and Toxic Term Sheets in Venture Capital

In a recent article in this journal, the authors documented the growing tendency of emerging growth companies to raise substantial equity while remaining privately held through private IPOs, or PIPOs. PIPO financing has created scores of “unicorn” firms—private enterprises with imputed market values of $1.0 billion or more—while allowing them to avoid the challenges of being publicly traded. But as has also been noted, the PIPO process, with its multiple financing rounds and increasingly complex terms, has almost certainly result in some inflated market valuations. Along with inflated values, the contracting process and many of the provisions that result from it often have economic consequences that are poorly understood by at least some of the participants, including the potential for significant wealth transfer between stakeholders as well as overall destruction of enterprise value. And the term sheets containing such provisions appear to become even more “opaque” and more “toxic” with each round of financing. More specifically, the liquidation preferences and ratchets often provided new investors in the later rounds of PIPOs can greatly affect the allocation of the risks and the ownership shares and, in so doing, transfer significant wealth from the entrepreneurs and other older owners. Using a numerical analysis of a representative term sheet, the authors discuss the process of financial contracting for early‐stage companies, providing examples of how negotiations can go wrong and showing exactly when and where the agreed‐upon conditions start to turn toxic for some of the stakeholders. The article closes with the authors’ assessment of the disincentives for entrepreneurs and early‐stage investors created by this often confusing and dilutive venture capital contracting and funding process.     

Information Quality and Long‐Run Risk: Asset Pricing Implications

I study the asset pricing implications of the quality of public information about persistent productivity shocks in a general equilibrium model with Kreps–Porteus preferences. Low information quality is associated with a high equity premium, a low volatility of consumption growth, and a low volatility of the risk‐free interest rate. The relationship between information quality and the equity premium differs from that in endowment economies. My calibration improves substantially upon the Bansal–Yaron model in terms of the moments of the wealth–consumption ratio and the return on aggregate wealth.     

Implied Equity Duration: A Measure of Pandemic Shutdown Risk

Implied equity duration was originally developed to analyze the sensitivity of equity prices to discount rate changes. We demonstrate that implied equity duration is also useful for analyzing the sensitivity of equity prices to pandemic shutdowns. Pandemic shutdowns primarily impact short‐term cash flows, thus they have a greater impact on low‐duration equities. We show that implied equity duration has a strong positive relation to U.S. equity returns and analyst forecast revisions during the onset of the 2020 COVID‐19 shutdown. Our analysis also demonstrates that the underperformance of “value” stocks during this period is a rational response to their lower durations.