Anomalies and Market (Dis)Integration∗

Any rational pricing phenomenon in the cross section of equity returns must also show up in the corresponding corporate bond returns. We use this powerful insight to investigate whether the equity and corporate bond markets are integrated with respect to risk premia associated with anomalies. We find that the two markets are not integrated through factors suggested by structural credit risk models. In particular, profitability and net issuance anomalies do not exist in corporate bond returns. For other anomalies such as asset growth and investment that also appear in bond returns, the associated risk premia are too large in comparison with risk premia implied by equity returns. This segmentation in the relative risk premia intensifies with high investor sentiment and is concentrated on the short side of anomaly portfolios, suggesting potential overpricing in corporate bonds. ∗We thank Lauren Cohen, Zhi Da, Adlai Fisher, Tim Johnson, Ralph Koijen, Matthew Richardson, Bernd Schwaab, Robert Whitelaw, and seminar participants at Chinese University of Hong Kong, Hong Kong University, Peking University, University of Illinois, RMI Annual Risk Management Conference at National University of Singapore, and Research in Behavioral Finance Conference at Erasmus University for helpful comments. †Assistant Professor, Department of Finance, University of Illinois at Urbana-Champaign. Address: 515 E. Gregory Dr., Champaign, IL 61820. Email: [email protected]. ‡Ph.D. Candidate, Department of Finance, University of Illinois at Urbana-Champaign. Address: 1206 S. Sixth St., Champaign, IL 61820. Email: [email protected].