Six variables that predict defaults

We discuss which variables can help us predict corporate defaults

The current pandemic is triggering a stark growth in corporate defaults, both in the US and internationally. Hertz, Neiman Marcus, J C Penney, Virgin Atlantic, Swissport, and Whiting are just some of the most well-known firms that have filed for bankruptcy in the last few months.

The graph below shows that the rate at which corporate defaults are rising in the US is higher than the one observed in the 2002 and 2009 financial crises.

From the point of view of an investor, it can be of great value to predict which firms are more likely to file for bankruptcy in the near future.

Are there any early signals that help us spot which firms are most likely going into default over the next 12 months?

Here are six variables that you should look at:

1. Profitability: measured as net income scaled by the sum of the market value of equity and total liabilities (NIMTA)

2. Leverage: measured as total liabilities scaled by the sum of the market value of equity and total liabilities TLMTA

3. Stock returns: measured as the monthly log stock return of a firm minus that of the index of the market in which the firm is headquartered (EXRET)

4. Size: measured as the log ratio of a firm’s market value to the sum of market values for all firms in the same market and month (RSIZE)

5. Volatility of stock returns: measured as the annualized standard deviation of a firm’s daily log stock returns in the prior three months (SIGMA)

6. Liquidity: measured as the ratio of cash and short-term assets to the sum of the market value of equity and total liabilities (CASHMTA)

The table below is from Aretz, Florackis and Kostakis (2020) and it shows that low NIMTA, high TLMTA, low EXRET, low RSIZE, high SIGMA and low CASHMTA are indicators of a higher probablity of default in the next 12 months.

The results pretty much apply to all six country in the table (Australia, Canada, France, Germany, Japan and UK). Similar results also apply to the U.S. and can be found in Anginer and Yildizhan (2017) and Campbell, Hilscher and Szilagyi (2008).

So, if you want to spot the firms that are more likely to file for bankruptcy, watch out for small firms reporting low profitability, high leverage, negative returns, high volatility and low cash!

References

1. 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.

2. 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.

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

4. 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.

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

6. 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.

7. 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.

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

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

10. Pandemic triggers wave of billion-dollar US bankruptcies https://www.ft.com/content/277dc354-a870-4160-9117-b5b0dece5360