Examining the Existence of the Financial Distress Risk Anomaly: Evidence from the U.S. Stock Market

Abstract: This paper examines the relationship between financial distress risk, estimated from a firm's distance-to-default, and equity returns on a sample of U.S. stocks between January 1990 and December 2019. We find monotonically decreasing returns in risk-sorted portfolios, while finding no risk-based explanation for these when benchmarking against the Fama-French three-factor and five-factor models. However, we do find that the Fama-French five-factor model appears to contribute with greater explanatory power. Additionally, we identify a financial distress risk anomaly yielding significant annualized monthly alphas in the range of 20-27% by constructing a long-short portfolio with a one-month holding period going long in the safest and short in the most distressed stocks. This effect is found to be stronger within a sub-sample of small stocks. Furthermore, the effect weakens as the holding period lengthens, with borderline significant and completely insignificant results for three-month and twelve-month holding periods respectively.