Institutional Preferences and the Distress Puzzle

Abstract

Explanations for the distress puzzle are highly controversial in the literature. This study uses stocks listed in Chinese equity markets to investigate the puzzle. This study employs “special treatment” stocks as proxies for near bankruptcy firms to estimate distress risk by the Ohlsen (1980) model. Consistent with U.S. studies, we find that the distress puzzle also exists in China. The study uncovers that institutions have a strong preference for low distress risk stocks. We propose two hypotheses with regard to the preference to explain the anomalous relationship between distress risk and stock returns, namely the change of the institution preference and the demand shock for low distress risk stocks. The results show that Oscore is not only a determinant of the level of institutional holdings, but also an important driving force for the contemporaneous change of institutional holdings. The sensitivity of Oscore to institutional holdings has significantly increased from the early to the later sample period. The findings provide strong support for the change of the institution preference to cause the distress puzzle, indicating that institutional investors in China become more like low distress risk stocks in now days than in past.