Bonds versus Equities: Information for Investment

Abstract

We provide a simple model of investment by a firm funded with debt and equity and empirical evidence to demonstrate that, once we control for the debt overhang problem with credit spreads,assetvolatility is an unambiguouslypositivesignal for investment, whileequityvolatility sends a mixed signal: Elevated volatility raises the option value of equity and increases investment for financially sound firms, but exacerbates debt overhang and decreases investment for firms close to default. Our study provides a simple unified understanding of the structural and empirical relationships between investment, credit spreads, equity versus asset volatility, leverage, and Tobin'sq$q$.