Distress Risk - Quality or Junk? Nordic evidence on the ability of distress risk to explain variations in stock returns

Sammanfattning: The risk-return paradigm suggests there should be a positive association between distress risk (i.e. the probability of firm failure) and subsequent excess stock returns. However, we present puzzling evidence suggesting investors are not compensated for taking on additional distress risk. To the contrary, we find that junk stocks (i.e. stocks with high levels of distress) earn lower than average returns during 2000 - 2014. In other words, results point to the absence of a distress premium, suggesting distress risk is not to be considered systematic. Stock price reactions following changes in distress offer one potential explanation to the anomalous findings. We find that the market tends to re-price stocks whose distress risk has increased (decreased) with a negative (positive) stock price adjustment. What is more, results point to a drift in stock prices following changes in distress risk. It is hence not unlikely that the absence of a distress premium observed in our results is driven by abnormal returns following periods of credit downgrades.