Debt Dynamics and Equity Performance: The Interplay Between Leverage Ratios, Debt Maturity, and US Stock Returns From 1980-2022

Caroline Amstrup Termansen & Markus Munck Sørensen

Student thesis: Master thesis


Since the 1950s, the topic of finance has been studied extensively. The CAPM was developed in the 1960s, and factor models were introduced in the 1970s to aid the explanatory power of the models regarding stock returns. Since then, a plethora of research has emerged with the purpose of creating significant alphas based on varying firm characteristics. The objective of this thesis is to examine whether the CAPM and other selected factor models effectively explain the equity returns of leverage and debt maturity-sorted portfolios. The motivation behind the topic was partly based on the extensive literature on capital structures of firms as well as the somewhat lacking body of research on leverage ratios and debt maturity’s impact on expected returns. This thesis considers portfolios created on the degree of leverage and debt maturity. It utilizes the CAPM, FF3, FF5, and C4 factor models in OLS and Fama-Macbeth regressions on the portfolios to examine how well the models explain the return patterns of the ten portfolios from 1980-2022. In conjunction with the regressions, the underlying portfolios have also been divided into two periods, 1980-2000 and 2000-2022, as well as five different size portfolios with the purpose of investigating whether the factor models’ degree of explanation differs across periods as well as between firm sizes. Lastly, the thesis utilizes a difference portfolio in accordance with previous research as the basis for a leverage factor to observe whether this factor has significant explanatory power over the portfolios. This thesis finds no clear patterns in the factors’ ability to explain returns, except for a negatively significant alpha for the most levered portfolio. The debt maturity regressions reveal no clear pattern other than negative alphas for the firms with the highest and lowest degree of short-term debt. Sizes were found to have a significant impact in collaboration with leverage ratios. The smallest firms consistently underperformed their expected returns, especially the smallest firms with the highest leverage ratios. In terms of the different periods, this thesis concludes that there is a substantial effect on the expected returns depending on whether the analyses were conducted in the first or last period, as the factor models capture more of the alphas in the last period. Lastly, the Fama-Macbeth regressions proved that the market beta serves as the most significant factor in capturing market risk, followed by CMA, RMW, and HML. The SMB, Momentum, and especially the leverage factors all had an insignificant impact on the returns of the portfolios. The above indicates that the return patterns are represented more optimally by the degree of investment, profitability, and book/market value of equity relative to the size of the firms, the prior year’s returns, and the degree of leverage

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
Publication date2023
Number of pages156
SupervisorsFabrice Tourre