Is Default Risk Negatively Related to Stock Returns?

Abstract

We find a positive cross-sectional relationship between expected stock returns and default risk, contrary to the negative relationship estimated by prior studies. Whereas prior studies use noisy ex post realized returns to estimate expected returns, we use ex ante estimates based on the implied cost of capital. The results suggest that investors expected higher returns for bearing default risk, but they were negatively surprised by lower-than-expected returns on high default risk stocks in the 1980s. We also extend the sample compared with prior studies and find that the evidence based on realized returns is considerably weaker in the 1952--1980 period. The Author 2009. Published by Oxford University Press. All rights reserved. For permissions, please e-mail: journals.permissions@oxfordjournals.org, Oxford University Press.