Yuhang Xing

Sector Investment Growth Rates and the Cross Section of Equity Returns

We examine the importance of the information contained in sector investment growth rates for explaining the cross section of equity returns. We propose an empirical specification that outperforms the capital asset pricing model and Cochranes (1996) model and performs at least as well as the Fama-French (1993) and Lettau-Ludvigson (2001) models in explaining the 25 Fama-French size-sorted and book-to-market-sorted portfolios, as well as other sets of test assets.

Value versus Growth: Time-Varying Expected Stock Returns

Is the value premium predictable? We study time-variations of the expected value premium using a two-state Markov switching model. We find that when conditional volatilities are high, the expected excess returns of value stocks are more sensitive to aggregate economic conditions than the expected excess returns of growth stocks. As a result, the expected value premium is time-varying: it spikes upward in the high-volatility state, only to decline more gradually in the ensuring periods. However, out-of-sample predictability of the value premium is close to nonexistent.

Taxes on Tax-Exempt Bonds

Implicit tax rates priced in the cross section of municipal bonds are approximately two to three times as high as statutory income tax rates, with implicit tax rates close to 100% using retail trades and above 70% for interdealer trades. These implied tax rates can be identified on the cross section of municipal bonds because a portion of secondary market municipal bond trades involve income taxes. After valuing the tax payments, market discount bonds, which carry income tax liabilities, trade at yields around 25 basis points higher than comparable municipal bonds not subject to any taxes. The high sensitivities of municipal bond prices to tax rates can be traced to individual retail traders dominating dealers and other institutions.

Build America Bonds

Build America Bonds (BABs) are a new form of municipal financing introduced in 2009. Investors in BAB municipal bonds receive interest payments that are taxable, but issuers receive a subsidy from the U.S. Treasury. The BAB program has succeeded in lowering the cost of funding for state and local governments with BAB issuers obtaining finance 54 basis points lower, on average, compared to issuing regular municipal bonds. For institutional investors, BAB issue yields are 116 bps higher than comparable Treasuries and 88 bps higher than comparable highly rated corporate bonds. For individual investors, BABs represent poor deals compared to regular municipal bonds. Thus, on average the Federal government subsidy disadvantages individual U.S. taxpayers, who are the main holders of municipal bonds, and benefits new entrants in the municipal bond market.

The Information Content of the Sentiment Index

Previous studies have shown that the “sentiment index” constructed by Baker and Wurgler (2006) is a powerful predictor of cross-sectional stock returns. We find that investor sentiment is strongly correlated with contemporaneous business cycle variables. About 63% percent of the total variation in the investor sentiment index can be explained by well-known, contemporaneous business cycle variables. We decompose the widely used investor sentiment index into two components: one related to standard business cycle variables and the other unrelated to those variables. We show that the power of the sentiment index to predict cross-sectional stock returns is mainly driven by the business cycle component, while the component unrelated to business cycle conditions has little significance in predicting cross-sectional stock returns. Our results suggest that the sentiment index’s predictive ability might result from its correlation with business cycle variables.

The Muni Bond Spread: Credit, Liquidity, and Tax

Municipal (muni) bonds are risky and trade in illiquid markets, and both effects serve to raise muni yields relative to Treasuries. On the other hand, the tax exemption of muni bonds tends to lower their yields. We decompose the muni yield spread into credit, liquidity, and tax components. Before 2008, muni yields are reliably lower than Treasuries. After the 2008 financial crisis, the muni-Treasury spread flips sign to, on average, 0.87%, comprising credit, liquidity, and tax components of 0.57%, 2.14%, and -1.84%, respectively. Muni credit and liquidity components exhibit strong covariation with credit and liquidity factors prevailing in other asset classes.

What Explains the Distress Risk Puzzle: Death or Glory?

Campbell, Hilscher, and Szilagyi (2008) show that firms with a high probability of default have significantly low average future returns. We show that there is a large overlap between stocks classified as high default risk, and those that are likely to produce extremely high returns over the next year (‘glory’ stocks). Predicted glory and predicted distress are highly correlated, with over 50% of firms in the top distress risk quintile also in the top quintile of predicted glory. Stocks with high predicted probabilities for glory also earn abnormally low average returns. We find evidence that low returns to high glory firms are also present in firms with zero leverage, where financial distress is unlikely, and that the low returns to high distress risk firms are large and significant in ‘speculative’ firms (with high sales growth and market-to-book ratios) that have high predicted glory; subsequent returns are small and statistically insignificant in ‘traditionally distressed’ firms. Thus, we show that, on average, firms which have a high potential for death (default) also tend to have a high potential for glory; where the two factors can be separated, the results suggest that it is glory, rather than distress, which is responsible for the low expected returns in securities.

Strategic Risk Shifting and the Idiosyncratic Volatility Puzzle

We find strong empirical support for the risk-shifting mechanism to account for the puzzling negative relation between idiosyncratic volatility and future stock returns documented by Ang, Hodrick, Xing, and Zhang (2006). First, equity holders take on high idiosyncratic risk investments when their firms receive negative cash flow shocks, have positive debt or have more long-term debt. Second, the strategically increased idiosyncratic volatility decreases the sensitivity of stocks to assets and results in low stock returns. Specifically, this strategic component alone explains 66.06 to 89.96% of the negative impact of total idiosyncratic volatility on future stock returns.