Equity investor sentiment and bond market reaction: Test of overinvestment and capital flow hypotheses

Abstract In this paper, I examine the effect of equity investor sentiment on the bond market. Sentiment can affect 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 firms that overinvest. Furthermore, 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 overinvestment firms. Additionally, I find a negative (but delayed) impact of equity investor sentiment on bond ratings for overinvestment firms, consistent with an increase in default risk of these firms. Overall, my study highlights that the bond market reacts to equity investor sentiment in a rational way, consistent with bond investors' payoff function.