Bonds, Stocks, and Sources of Mispricing

This paper shows that investor sentiment and financial distress jointly drive the equity overpricing underlying market anomalies. In particular, the intersection of high sentiment and rating downgrades of distressed firms characterizes episodes of inflated stock and bond prices to the extent that assets are correctly priced beyond such episodes. Overpricing among stocks and bonds emerges when sentiment-driven investors consistently underestimate the implications of financial distress for high credit risk firms.