Switching Perspective: Corporate Distress, Asset and Financial Risk, and the Cross-Section of Bond Returns

Abstract

We offer evidence suggesting a significantly negative relation between firm-level distress risk and the cross-section of corporate bond returns, analogous to the often negative relation between distress risk and stock returns found in prior studies (distress anomaly). Our evidence casts doubts on theories arguing that the distress anomaly arises due to shareholders shifting financial risk onto debtholders in distress. In accordance, proxy variables suggested by such theories do not condition the distress risk-bond return relation. More promising, however, are theories suggesting that the anomaly arises due to distressed firms having a low levered asset risk due to them owning valuable disinvestment options, with some of the proxy variables suggested by these theories conditioning the former relation.