Distressed, but not risky: Reconciling the empirical relationship between financial distress, market-based risk indicators, and stock returns (and more)

Stock prices are a fundamental tool for identifying financially distressed firms. However, contrary to conventional wisdom, distressed firms have lower stock returns, while book-to-market values, frequently associated with distress, are positively related with stock returns. A model that decouples real (observed) from risk-neutral probabilities of default can reconcile these phenomena. This model also fits other empirical regularities, e.g., firms with higher bond yields have higher stock returns, and book-to-market value dominates financial leverage in explaining stock returns. The model predicts that firms with a higher risk-neutral probability of default should have higher stock returns, a hypothesis consistent with recent findings. JEL Codes: G12, G32, E44 E-mail: ali.ozdagli@bos.frb. org. Address: Federal Reserve Bank of Boston, 600 Atlantic Ave, Boston, MA-02210. The views expressed in this paper do not necessarily reflect those of the Federal Reserve Bank of Boston or the Federal Reserve System. An earlier version of this paper has been distributed in various seminars and conferences under the title "The Distress Premium" and is scheduled for presentation at the AEA 2013 meetings. I am grateful to Anat Bracha, Michelle Barnes, Ron Butler, Hui Chen, Burcu Duygan-Bump, Joe Peek, Christina Wang, and the participants of the 2011 meeting of WFA, 2012 meeting of EEA/ESEM, and the Brandeis IBS research seminar, in particular Jens Hilscher and Hong Yan, for detailed comments and discussions. Sarojini Rao and Yifan Yu provided first-rate research assistance and Suzanne Lorant provided excellent editorial assistance. All errors are mine. The recent financial crisis has highlighted the need for economists and policymakers to identify financially distressed firms. Stock prices seem to be the most versatile tool for this purpose because of the frequency and availability of information. Since conventional wisdom suggests that financially distressed firms have higher risk and lower market values than other firms, they should have higher expected stock returns and higher market-based risk indicators, such as book-to-market and earnings-price ratios. Therefore, financial distress may also be the link accounting for the value premium, i.e., the positive relationship between stock returns and market-based indicators, as argued frequently in the literature. 1 This claim has been scrutinized by several papers that use historical observations of loan defaults to estimate firms’ default probabilities as a distress proxy. As Table I illustrates, they reach the puzzling conclusion that book-to-market ratios have a low correlation with default probabilities and that financially distressed firms have lower returns. 2 The solution to this distress premium puzzle is important for academics because it poses a challenge to standard models of rational asset pricing, and for policymakers because they use stock market data to infer the financial health of firms. This paper argues that the distress premium puzzle can be solved by distinguishing between the default probabilities under real (observed) and risk-neutral probability distributions. While the real distribution describes only the likelihood of different monetary payoffs, the risk-neutral distribution also incorporates information about how investors value these payoffs. Since this additional information is missing from loan default observations, the aforementioned literature concentrates on the estimation of default probabilities under the real distribution. However, this 1See Fama and French (1992) for an early example and Gomes and Schmid (2010) for a recent example of this argument. 2See, for example, Dichev (1998), Griffin and Lemmon (2002), and Campbell, Hilscher, and Szilagyi (2008). One exception is Vassalou and Xing (2004), who find a positive relationship between stock returns and a distress measure that mimicks KMV’s Expected Default Frequency (EDF). Da and Gao (2010) argue that their result is driven by short-term return reversals in a small subset of stocks. Using the actual EDF measure, Garlappi, Shu, and Yan (2008) and Gilchrist, Yankov, and Zakrajsek (2009) find that firms in the highest EDF quintile have the lowest returns.