Is there a systematic component to distress risk?
We investigate whether the systematic component of distress risk carries a premium
Asset pricing theory states that those who bear systematic risk shall be rewarded with higher expected returns. It does not say that expected returns increase with exposure to risk in general. It is only the systematic component of risk that matters.
For most part of our discussion on distress investing in previous articles, we have talked about distress risk loosely, implicitly assuming that all distress risk is systematic in nature. The figure below (from Anginer and Yıldızhan, 2018) shows that indeed most bankruptcies occur during a recession (in grey). This validates the idea that distress risk is by and large systematic.
Yet, the question remains: would it make a difference in terms of returns, if we focused only on the systematic component of distress risk, rather than on distress risk in general? The answer is YES. Stocks with higher systematic distress risk exposure have higher expected equity returns.
The problem is: how do we measure exposure to the systematic distress risk? There is more than one way to do it. Here, we extract systematic distress risk using corporate bond spreads.
Credit spreads of bonds are made up of several components, over and beyond credit risk. Spreads also contain an element of liquidity risk and taxes, among other effects.
Driessen and de Jong (2007), Elton et al. (2001) and Campello, Chen, and Zhang (2008) have developed a methodology to extract the credit risk premium contained in corporate bond spreads, in a way that separates that systematic component of distress risk from a liquidity premium and taxes. The figure below (from Anginer and Yıldızhan, 2018) provides an example of such decomposition.
The next step is to sort stocks according to their exposure to systematic distress risk, and see if there is a positive relation with equity returns. This exercise is done by Anginer and Yıldızhan (2018) in the table below.
The column “excess returns” shows that as we move from portfolios with low exposure to systematic distress risk to those with high exposure, monthly excess returns increase. The difference in average monthly excess returns between the bottom and top decile is 0.521%. This shows that systematic distress risk is indeed priced by the market in terms of the associated equity returns. That is the good news.
The bad news is that most of this pricing effect is already captured by other known factors. Once we control for market beta in column “CAPM alpha”, the systematic distress premium disappears. And the same holds once we look at the alpha of a three and four-factor model (that includes market, size, value and momentum). This was the topic of a previous post of ours.
So, all in all, we have made progress. We now know that taking up systematic distress risk generates a premium. A long-short systematic distress strategy should then give positive returns. However, we also know that this premium is absorbed by the exposure to other common risk factors.
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
Campello, M., Chen, L., and Zhang, L. (2008) Expected returns, yield spreads, and asset pricing tests, Review of Financial Studies 21, 1297–1338.
Driessen, J. and de Jong, F. (2007) Liquidity risk premia in corporate bond markets, Management Science 53, 1439–1451.
Elton, E. J., Gruber,M. J., Agrawal, D., and Mann, C. (2001) Explaining the rate spread on corporate bonds, Journal of Finance 56, 247–277.
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