Is There a Distress Risk Anomaly? Corporate Bond Spread as a Proxy for Default Risk
Although financial theory suggests a positive relationship between default risk and equity returns, recent empirical papers find anomalously low returns for stocks with high probabilities of default. The authors show that returns to distressed stocks previously documented are really an amalgamation of anomalies associated with three stock characteristics -- leverage, volatility and profitability. In this paper they use a market based measure -- corporate credit spreads -- to proxy for default risk. Unlike previously used measures that proxy for a firm's real-world probability of default, credit spreads proxy for a risk-adjusted (or a risk-neutral) probability of default and thereby explicitly account for the systematic component of distress risk. The authors show that credit spreads predict corporate defaults better than previously used measures, such as, bond ratings, accounting variables and structural model parameters. They do not find default risk to be significantly priced in the cross-section of equity returns. There is also no evidence of firms with high default risk delivering anomalously low returns.
Summary: | Although financial theory suggests a
positive relationship between default risk and equity
returns, recent empirical papers find anomalously low
returns for stocks with high probabilities of default. The
authors show that returns to distressed stocks previously
documented are really an amalgamation of anomalies
associated with three stock characteristics -- leverage,
volatility and profitability. In this paper they use a
market based measure -- corporate credit spreads -- to proxy
for default risk. Unlike previously used measures that proxy
for a firm's real-world probability of default, credit
spreads proxy for a risk-adjusted (or a risk-neutral)
probability of default and thereby explicitly account for
the systematic component of distress risk. The authors show
that credit spreads predict corporate defaults better than
previously used measures, such as, bond ratings, accounting
variables and structural model parameters. They do not find
default risk to be significantly priced in the cross-section
of equity returns. There is also no evidence of firms with
high default risk delivering anomalously low returns. |
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