Debt externality in equity markets: Leveraged portfolios and Islamic indices

This paper tests for the externality of debt in the equity markets. Adopting an exogenous view of the business cycles and assuming myopia amongst borrowers and lenders, the paper argues that when the markets are going up, portfolios and indices with high debt should perform better than those with low debt, while during the downward phase, low debt portfolios and indices would perform better. We use firm as well as index level data to compare performance based on high and low debt in the up and down market and conduct a series of robustness tests. We use monthly data from 2555 listed nonfinancial US firms from 1982 to 2016 to create low and high debt portfolios. At the index level, we use Islamic indices as a proxy for low debt indices. Our results show that low debt portfolio and Islamic indices outperform the high debt portfolio and conventional indices in the down market and underperform in the up market, respectively. The paper contributes to the literature on debt externality by extending the idea to the equity markets. The paper also contributes to the Islamic finance literature by identifying their better performance in the down markets. We theorize that the low debt of Islamic equity indices could be the moderating cause of their better performance.