The Distress Anomaly is Deeper than You Think: Evidence from Stocks and Bond
Doron Avramov, Tarun Chordia, Gergana Jostova, Alexander Philipov
Review of Finance, Volume 26, Issue 2, March 2022, Pages 355–405, https://doi.org/10.1093/rof/rfab025
This paper provides new evidence on the distress anomaly based on a comprehensive sample of stocks and corporate bonds. The distress anomaly represents a puzzling cross-sectional effect because high credit risk securities realize abnormally low returns even when they are markedly riskier than low credit risk securities. This challenges the basic risk-return paradigm in finance. The literature has proposed several rationales to resolve the distress anomaly, including transfer of wealth from bondholders to equity holders, time-varying beta, lottery type preferences, institutional trading, and limits to arbitrage. These rationales have been tested using only stocks. Our paper emphasizes the important role of corporate bonds in dissecting the distress anomaly.
First, we show that the distress anomaly extends to corporate bonds, which provides out-of-sample reinforcement of the puzzle. In addition, corporate bonds lead to new implications for existing rationales because their payoff structure, liquidity, and investor base are different from those of stocks. We show that existing rationales for the distress anomaly are inconsistent with the return patterns of corporate bonds. We argue that the most coherent rationale for the distress anomaly is underreaction to financial distress, even by the most sophisticated investors who dominate fixed income markets.
In addition, the distress anomaly implies real distortions in the real economy because corporate decisions are undertaken based on incorrect asset prices. We provide suggestive evidence that real distortions are economically significant and moreover they are severely understated if measured only based on equity mispricing. In particular, real distortions due to both equity and bond mispricing are significantly larger than those based only on equity mispricing. Examples of real distortions include excess investments, excess debt financing, and excess equity issuance.
We conclude that the distress anomaly is an unresolved puzzle, deeper than previously thought. In addition, the puzzle is associated with potentially severe implications for the real economy.