Equity misvaluation and debt markets

Abstract

This study examines whether equity misvaluation is associated with credit risk. Credit risk can be argued as not being associated with equity misvaluation because equity misvaluation is noisy information relative to a borrower's intrinsic value. Instead, we hypothesize a nonlinear relationship between credit risk and firm misvaluation. We examine new bond issues between 1990 and 2018. Our results show that equity valuations higher than the intrinsic value are negatively associated with credit risk through higher credit ratings, lower bond yields, and a lower distance to default until analysts and creditors perceive that the firm becomes excessively overvalued. After that turning point, the association flips, and firm equity valuations become positively associated with credit risk.