Systematic default and return predictability in the stock and bond markets

We construct a measure of systematic default defined as the probability that many firms default at the same time. We account for correlations in defaults between firms through exposures to common shocks. Systematic default spikes during recessions, is correlated with macroeconomic indicators, and predicts future realized defaults. More importantly, it predicts future equity and corporate bond index returns both in-and out-of-sample. Finally, we find that the cross-section of average stock returns is related to firm-level ex-posures to systematic default risk. & COPY; 2023 Elsevier B.V. All rights reserved.