The distress anomaly: Where finance theory breaks down

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Alexander Philipov
Alexander Philipov

Exceptions may prove the rule, but they must first be explained. That is why finance researchers are drawn to the distress anomaly-- a well-documented phenomenon that challenges the risk-return paradigm in equity markets. Generally, higher-risk investments are expected to yield higher returns than safer, more stable securities. In recent years, however, studies have shown that high-credit-risk securities for companies in distress – i.e. when their already-low credit rating is being downgraded -- realize abnormally low returns compared to non-distressed securities of the same or lower risk.  

Academics have proposed a range of rationales for this puzzle. Alexander Philipov, finance area chair and associate professor at George Mason University, says they mainly fall into two categories. One is risk-based, stating that the pattern could be explained by time-varying risk (e.g. having low risk in bad times), or by hidden value transfers during bankruptcy, when equity holders could extract value from other stakeholders. The other rationales look at possible investor biases, such as investors having lottery type preferences and chasing after sky-high returns in an unlikely recovery from distress. Other psychological biases, such as tendencies to hold on to losing stocks in the hope they would turn around may also be at play. These biases would be exhibited by retail investors while institutional investors are not likely susceptible to them. As yet, there is no consensus among academics on which rationales, if any, get closest to the truth of the distress anomaly.  

Philipov’s recent paper in Review of Finance[1] is the first to show that the distress anomaly extends to corporate bonds. In addition, the anomaly is associated with potentially severe implications for the real economy. The researchers documented this by comparing the stock and bond portfolios of distressed firms with those of other portfolios. 

Corporate bonds help evaluate existing rationales because their payoff structure, liquidity, and investor base are different from those of stocks. The study shows that existing rationales for the distress anomaly are inconsistent with the return patterns of corporate bonds. Specifically, rationales involving value transfers from bondholders to stockholders are inconsistent with the data showing that both bonds and stocks of distressed firms are similarly overpriced. Furthermore, the anomaly is more pronounced in market downturns, as is the distressed stocks and bonds’ risk—evidence against the time-varying risk story.  

The study also finds the distress anomaly implies real distortions in the real economy because corporate decisions are undertaken based on incorrect asset prices. These suboptimal decisions may include excess investments, and over issuance of debt and equity. “We provide suggestive evidence that real distortions are not only economically significant but also severely understated if measured based on equity mispricing alone (as in previous studies). Adding bonds brings new light to the magnitude of these distortions,” says Philipov. 

Based on the new bond evidence, the most coherent rationale for the distress anomaly appears to be underreaction to financial distress, even by the most sophisticated investors. The researchers conclude that the distress anomaly is an unresolved puzzle, deeper than previously thought.  

Philipov suggests that future research on the distress risk anomaly may focus on alternative ways of measuring risk or on new advances in behavioral finance, such as cumulative prospect theory which focuses on how investors under- or overestimate probabilities. Clues may also lie in the investment strategies of smart market actors. “If there are many investors with biases, especially biases that you could possibly predict, you should be able to find market players which are exploiting these biases,” Philipov says. Lack of evidence of such profit-taking activity may imply that trading frictions may be too high to take advantage of pricing misalignments. Yet another promising research strategy could be to look beyond the data, into what really goes on behind the scenes at distressed companies. “Maybe what those public investors are losing, there are some players that are gaining from it,” Philipov says. “But we’re not able to observe that.” 

He further suggests that interdisciplinary work may be able to tackle questions such as, “Do distressed companies advertise more or less? Do they allocate less for research? What do their operations look like? Are they trying to apply new management techniques or are they quickly losing talent?”  

Academics are drawn to find explanations to market phenomena like the distress anomaly where theory breaks down. “We should be trying to explain what’s going on, because that’s where you get new insights: studying corners where things aren’t working as general theory dictates,” Philipov says. 

[1] Co-authored by Doron Avramov of ISC Herzliya, Tarun Chrodia of Emory University and Gergana Jostova of George Washington University.