The term structure of credit spreads, firm fundamentals, and expected stock returns

We explore the link between credit and equity markets by considering the informational content of the term structure of credit spreads. A shallower credit term structure predicts decreases in default risk and increases in future profitability, as well as favorable earnings surprises. Further, the slope of the credit term structure negatively predicts future stock returns. While systematic slope risk is priced, information diffusion from the credit market to equities, particularly in less visible stocks, plays an additional role in accounting for return predictability from credit slopes. That is, such predictability is less evident in stocks with high institutional ownership, analyst coverage, and liquidity, and vice versa.