Is there alpha in distressed stocks across the world?

We investigate the existence of a distress premium, controlling for common factors such as market beta, size and value, around the world.

One of the most puzzling pieces of evidence in asset pricing is the low performance of firms with high credit risk. This irregularity is known as the financial distress puzzle.

In previous posts, we have discussed this irregularity in the US market. We now look at the evidence outside the US.

The table below is from Gao, Parsons and Shen (2017). It reports the average returns and alphas for long/short portfolios that buy stocks with a high probability of default and sell stocks with a low probability of default. Panel A refers to the US market, while panel B refers to a large set of countries across the EU, Asia and emerging markets.

The table is constructed in the following way: at the end of each month, stocks are ranked within their country by their expected probability of default and then deciles are formed. The authors then build a long-short strategy that buys the decile with the highest probability of default, and sells the decile with the lowest probability of default.

The table reports the average raw monthly returns (value-weighted), alphas from the Fama-French-Carhart four-factor model (FFC4-α), and alphas from the Hou-Karolyi-Kho four-factor model (HKK4-α). Results for various holding periods are shown, including one month (t+2), three-month (t+2, t+4), and one year (t+2, t+13).

The column “Return” shows that returns of the long-short strategy are negative on average for the one month holding period, both in the US and outside the US, and within the group of large and small firms. In the US they average -0.35% per month, while outside the US they average -0.34% per month.

Returns are also negative at the three-month holding period. Instead, returns turn positive at the one-year holding period.

Alphas of the Fama-French-Carhart and Hou-Karolyi-Kho four-factor models are always negative across all holding periods.

This means that there is no value added by a long-short distress strategy over and above the factors included in the models. These factors are market, value, size and momentum for the FFC4, and market, cashflow-to-price, size and momentum for HKK.

In summary, it is worth investing in a long-short distress strategy only if you focus on US stocks and hold the portfolio for one year.

If your portfolio already has exposure to the four factors mentioned above, there is no value in taking additional exposure to distress risk, as the alpha that this exposure carries is always negative, across all horizons in the US and outside the US.

References

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.