Equity Investor Sentiment and Bond Market Reaction: Test of Overinvestment and Capital Flow Hypotheses

This paper examines the effect of equity investor sentiment on the bond market. While empirical evidence suggests that high investor sentiment leads to equity overvaluation, there is limited evidence of its effect on the bond market. Sentiment can have a negative impact on bond returns via two channels. First, in times of high investor sentiment, overvalued equity can lead to firm overinvestment, resulting in a negative impact on bond pricing due to an increase in default risk. Second, overvalued equity attracts capital flow to the equity market from the bond market which can create a downward pressure on bond pricing. Consistent with these channels, I find that equity investor sentiment exhibits a significant negative relation with contemporaneous bond returns; this effect is stronger for the sample of firms with overinvestment. In distinguishing the effects of the two channels, I find a positive relation between sentiment and subsequent bond returns, consistent with a return reversal predicted by the capital flow channel (due to the backflow of capital); however, there is no return reversal observed for the overinvestment sample, indicating that overinvestment has a more lasting impact. Additionally, I find a negative (but delayed) impact of equity investor sentiment on bond ratings for the overinvestment sample consistent with an increase in default risk of these firms. Overall, my study highlights that behavioral biases in the equity market do not automatically get transmitted to the bond market. In fact, the bond market reacts negatively to sentiment-induced overinvestment in a rational way, consistent with bond investors' payoff functions.