Predicted Firm Default Spikes and Future Asset Returns

Does an expectation of an unusually large number of firm defaults in the coming year usefully predict stock and bond market returns? In their May 2023 paper entitled “Systematic Default and Return Predictability in the Stock and Bond Markets”, Jack Bao, Kewei Hou and Shaojun Zhang apply an iterative process to estimate the probability that non-financial, non-microcap firms will default during the next year due to exposures to common shocks. The main inputs for their estimate are: (1) firm-level balance sheets and past stock returns; and, as common shocks, (2) past stock market returns. They relate estimated next-year default rate probability, focusing on a threshold of 2% of firms, to future stock market and corporate bond market index returns at horizons from one month to five years. They conduct in-sample tests of the default rate probability-index return relationships based on all data. They conduct out-of-sample index return predictions based on inception-to-date data starting at the sample half-way point. For robustness, they consider default rate probability thresholds other than 2%. Using firm balance sheets/monthly stock returns, plus monthly value-weighted U.S. stock market index and Dow Jones Corporate Bond Return Index returns during March 1961 through December 2021, they find that: (more…)