Debt overhang and return for investors: an inter‐sector analysis 

In this master thesis, we analysed companies’ return in the US according to their leverage (debt to equity) ratio, in order to try determining to which extent the financial distress and debt overhang risk come under consideration for investors. As from the S&P 1500 index, we divided our stock sample into 6 portfolios by sorting them firstly in two groups according to size (market capitalization) and further these two groups into three groups according to companies’ leverage ratio. Next, we applied this method for each economic sector of our sample. Our main results suggest that return decreases when leverage increases which is contrary to our initial expectation that the investor is supposed to be remunerated for the risk he bears and that investing in a highly leveraged company involves more risk than investing in a low-leveraged company. As a consequence of these results, low leveraged companies yield a higher return than more leveraged companies. Then, we tried to determine whether this “over-performance” of low leveraged companies is due to differences in exposure to systematic risks. We regressed our annual excess returns (in excess of the one-year U.S. risk free rate) by using the same explanatory variables than those used in the literature and especially the three variables of the Fama & French three-factor model, namely the equity market risk (ERP), the size factor (SMB) and the value factor (HML). When comparing the risk exposure for these three factors among our portfolios, we observed that low leverage portfolios have more exposure to the SMB factor and that high leverage portfolios have higher loadings for HML than low leverage portfolios. Our findings suggest that leverage ratio is an interesting variable to consider for investors.