Three essays on corporate bonds and their impacts on firms' investment decisions

This dissertation studies corporate bond investment, the momentum effect across stock returns and bond returns, and the impact of a firm's default risk on its investment decision.; In the first essay, we examine the momentum effect and its possible causes in both corporate bond and stock markets. We observe a significant momentum effect in corporate bond returns and bond credit spread changes. The momentum effect in bond returns, however, is confined to low-grade bonds and can be attributed to compensation for bearing a varying default risk and term risk. On the other hand, past spread changes have robust predictive power for future spread changes even after controlling for risk characteristics such as duration and yield-to-maturity. This essay also documents the integration of the momentum effect across bond and stock markets. Equity returns, bond returns and bond spread changes are contemporaneously correlated. In a study of lead-lag relation, we find that equity momentum exhibits spillover to both bond returns and spread changes, although the spillover to bond returns can only be observed after controlling for default risk. On the other hand, although past bond returns have no predictive power for future stock returns, past spread changes can explain half of momentum profit in future stock returns. This result indicates that the persistence in the default risk change may play an important role in understanding the source of momentum profits in equity returns.; These results also suggest that neither stock nor bond is leading in firm-specific information. They carry similar information content and underreact to the change in firm fundamentals.; In the second essay, we examine the relationship between a firm's default risk and its risk-shifting behavior, a well-known "asset substitute" problem. Using an approach similar to the one used by Moody's KMV, we show that firms with high default risk tend to increase asset volatility more in the subsequent year, relative to their industry peers. This is consistent with conventional wisdom and many theoretical models. Evidence also indicates that the change in the volatility of asset returns is negatively related to firm size, leverage, and the volatility of asset returns in the current year. Furthermore, we find that a firm's risk-shifting is also pronounced when it has very low default risk, which can be related to a firm's optimal risk-taking in a trade-off between return and default risk.; In the third essay, we conduct an analysis on the risk and return characteristics for distressed corporate bond investment based on two market indexes that we construct---the Defaulted Bond Index and the Distressed Bond Index. We find that the defaulted bond and the distressed bond are two distinct "asset classes" and have different risk-return characteristics. Furthermore, we show that our market indexes have specific power in explaining the returns of distressed securities hedge funds and can be used as systematic risk factors in distressed security investment.