How much is default risk captured by other factors?

Is there a distress risk factor? And how much of this factor is explained by other risk factors?

In previous posts, we have discussed the profitability of a strategy that is long on stocks with a high probability of distress stocks, and short on stocks with low probability of distress. Our conclusions were that on average both in the US and outside the US such strategy yields a negative expected return.

Additionally, we have shown that the strategy carries a negative alpha with respect to the Market, Size, Value and Momentum factors.

We now dig deeper into the relation between distress risk and the above four factors.

The figure below is from Aretz, Florackis and Kostakis (2018). It shows how the exposure to the different factors changes, as we increase the exposure of our portfolio to default risk.

The figure is built by first estimating the probability of default using the model of Campbell, Hilscher and Szilagyi (2008). Stocks are then divided in deciles according to their probability of default, with 10 representing the decile with the highest probability. For each portfolio, the authors estimate the exposure to the excess market return (market beta), the size (SMB), value (HML) and momentum (MOM) factors.

The sample period is 2000–2014. Factor loadings arepresented for portfolios of stocks from C6 countries (Australia, Canada, France, Germany, Japan, and the United Kingdom) and C14 countries (the C6 countries plus Denmark, Finland, Hong Kong, New Zealand, Portugal, Spain, Sweden, and Taiwan).

From the figure, the following facts emerge: higher default risk implies a higher beta with respect to the market, a higher beta to the HML factor and a negative beta to MOM. The relation with SMB is less obvious, however it is true that the high default portfolios have high exposure to SMB.

The positive relation between default risk and market beta is likely due to the fact that most defaults happen when there is a recession, which implies that market drops capture some default risk.

The negative relation with MOM is due to the fact that many firms in distress have experienced negative returns in previous months. So, the relation is mechanical.

In sum, a portfolio that loads on distress risk is one that carries much exposure to market risk, and to the value and size factors. Typically this portfolio will have experienced negative momentum.

References

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.