|A fundamental principle in the financial literature is that assets with exposure to systematic risk should be compensated with a risk premium in returns. Thus, assuming financial distress risk is systematic, rational investors are expected to demand a premium for holding stocks with exposure to financial distress. However, several academic papers find anomalously low returns for stocks with a high degree of financial distress. This anomaly is referred to as the “distress risk puzzle”.
In this paper we explore the relationship between distress risk and stock returns for publicly traded companies in Norway in the period from June 2004 to September 2018. We use default probability as a proxy for financial distress and estimate default probabilities by incorporating Campbell, Hilscher and Szilagyi’s (2008) best model. We allocate the stocks into eight different portfolios depending on their level of financial distress and measure the respective returns of the different portfolios. The returns are measured for three months, before the portfolios are re-balanced based on updated default probabilities.
Assuming distress risk is systematic, we would expect the distressed stocks to carry a premium. Thus, our null hypothesis is that investors who hold the most distressed stocks in the market over time will receive a risk premium. However, we find that the portfolio with the most distressed stocks significantly underperforms the portfolio with the least distressed stocks. This finding is also prevalent in risk-adjusted returns, estimated by regressing the portfolio returns on the risk factors in the Fama-French three-factor model. We also find that the most distressed firms on average are smaller in size, have higher market-to-book ratios and a higher degree of leverage.
From the results of our analysis, we can reject the null hypothesis that the most distressed stocks carry a premium. This indicates that there is a distress risk puzzle in the Norwegian market.