Is there alpha in distressed stocks? (U.S. evidence)

We investigate whether distressed stocks carry a premium after controlling for the exposure of the portfolio to common factors, such as CAPM Beta, Size and Value.

In a previous post, we examined the financial distress puzzle. This puzzle is born out of a contrast between theory and evidence.

Theory suggests that distressed stocks should carry a return premium over healthy stocks because they are higher risk. Instead, the evidence shows that distressed stocks yield a lower return (i.e. a discount) than investing in healthy stocks.

In this post, I investigate if the lower return of distressed stocks holds after controlling for exposure to the market, size, value and momentum factors.

The table below is from Anginer and Yıldızhan (2018). Stocks are sorted into deciles each month from January 1981 to December 2010 according to their estimated probability of default, obtained at the beginning of the previous month. As you scroll down the rows, you move to portfolios of firms that have an increasingly high probability of default.

The first column in the table reports the average monthly return of each of the ten portfolios in excess of the risk free rate. It is immediate to notice that the excess returns of the portfolios drop as we move from the portfolios with low distress risk to those with high distress risk. The difference High-Low is -1.184% per month. In other words, if you were to buy the stocks in the high distress portfolio and sold the stocks in the low distress portfolio, you should expect to lose 1.184% per month with respect to treasury bonds.

The second column in the table reports the average monthly return of each of the ten portfolios in excess of the risk free rate controlling for the exposure to the market (CAPM beta). The column shows that the alpha of the distress factor after controlling for the CAPM beta is still lower for low distress firms than for high distress firms. In other words, in terms of alpha, there is a discount associated with investing in high distress firms.

The third and fourth column report similar results after controlling respectively for three factors (market, size, and value) and for four factors (market, size, value and momentum). The alpha of high risk firms is negative, while that of low risk firms is positive. Once again, in terms of alpha, there is a discount associated with investing in high distress firms.

The last three columns (MKT, SMB and HML) report the average beta of each portfolio with respect to the market factor (MKT), to the size factor (SMB) and to the value factor (HML). Columns MKT, SMB and HML show that as we move from portfolios with low to high default probability, the exposure to the market and size factor increases. The relation to the value factor is less clear.

In other words, the portfolios with high expected default tend to have a higher market beta and tend to be smaller.

Hence the puzzle, how can it be that portfolios with a higher probability of default, that also have higher market beta and higher exposure to the size factor, carry lower returns?

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.