We summarise all the findings of our articles on distress risk

First, financial distress can be predicted by looking at a relatively small set of accounting and market variables, namely: profitability, leverage, stock returns, size, volatility of stock returns, and amount of liquid assets.

Second, exposure to distress risk carries a discount. Historically, a long-short strategy that buys stocks with a high probability of distress, and sells stocks with a low probability of distress has generated a negative performance. This evidence is known as the distress risk discount (Doubt: could it be that we are not predicting defaults correctly?)

Third, the average low performance of the long-short distress portfolio does not apply to a bear market and to the market rebound in a bear market. That is to say, while on average a long-short distress strategy carries negative returns, under specific market conditions the opposite is true.

Fourth, the distress risk discount, observed on raw returns, holds also in terms of alphas once we control for common risk factors (market, value, size, momentum).

Fifth, the evidence on the alpha of distress risk being negative applies both in the US and international markets.

Sixth, higher default risk implies a higher beta with respect to the market, a higher beta to the value factor and a negative beta to momentum. The relation with the size factor is less obvious. Nevertheless, these four risk factors are not fully capable of explaining the negative alpha of distress risk.

Seventh, systematic distress risk carries a premium rather than a discount. Thus, the evidence turns around if one looks at only the systematic component of distress risk, rather than at distress risk in general.

Eighth, stocks in distress have a high probability of generating jackpot returns, ie. greater than 100%.

Ninth, jackpot stocks are heavily bought by retail investors (a.k.a Robinhoods). The share performance of some recently distressed stocks, such as Hertz, has been pushed through the roof by Robinhood investors.

Here are some open questions:

Could it be that the large inflows of capital by Robinhoods into distress stocks depress their expected returns, thus causing the distress risk discount?

Do we have a convincing explanation for the distress discount? Is it just due to noise in how distress risk is measured?

References

• Anginer, D. and Yıldızhan, Ç., 2018. Is there a distress risk anomaly? Pricing of systematic default risk in the cross-section of equity returns. Review of Finance, 22(2), pp.633-660.

• Aretz, K., Florackis, C. and Kostakis, A., 2018. Do stock returns really decrease with default risk? New international evidence. Management Science, 64(8), pp.3821-3842.

• Campbell, J.Y., Hilscher, J. and Szilagyi, J., 2008. In search of distress risk. The Journal of Finance, 63(6), pp.2899-2939.

• Conrad, J., Kapadia, N. and Xing, Y., 2014. Death and jackpot: Why do individual investors hold overpriced stocks?. Journal of Financial Economics, 113(3), pp.455-475.

• Eisdorfer, A. and Misirli, E.U., 2020. Distressed stocks in distressed times. Management Science, 66(6), pp.2452-2473.

• Friewald, N., Wagner, C. and Zechner, J., 2014. The cross‐section of credit risk premia and equity returns. The Journal of Finance, 69(6), pp.2419-2469.

• Gao, P., Parsons, C.A. and Shen, J., 2018. Global relation between financial distress and equity returns. The Review of Financial Studies, 31(1), pp.239-277.

• Garlappi, L. and Yan, H., 2011. Financial distress and the cross‐section of equity returns. The journal of finance, 66(3), pp.789-822.

• Kapadia, N., 2011. Tracking down distress risk. Journal of Financial Economics, 102(1), pp.167-182.