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 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.