Is there a Distress Risk Anomaly? Corporate Bond Spread as a Proxy for Default Risk

Abstract

The standard measures of distress risk ignore the fact that firm defaults are correlated and that some defaults are more likely to occur in bad times. We use risk premium computed from corporate credit spreads to measure a firm’s exposure to systematic variation in default risk. Unlike previously used measures that proxy for a firm’s physical probability of default, credit spreads proxy for a risk-adjusted default probability and thereby explicitly account for the non-diversifiable component of distress risk. In contrast to prior findings in the literature, we find that stocks that have higher credit risk premia, that is stocks with higher systematic default risk exposures, have higher expected equity returns which are largely explained by the market factor. We confirm the robustness of these results by using an alternative systematic default risk factor for firms that do not have bonds outstanding. Consistent with the theoretical result in George and Hwang (2010), we also show that firms react to increases in their systematic default risk exposures by reducing their leverage, leading to lower physical probabilities of distress. Our results show no evidence of firms with high systematic default risk exposure delivering anomalously low returns.