Is The Risk Of Bankruptcy A Systematic Risk?

Is the Risk of Bankruptcy a Systematic Risk?

ILIA D. DICHEV*

ABSTRACT

Several studies suggest that a firm distress risk factor could be behind the size

and the book-to-market effects. A natural proxy for firm distress is bankruptcy

risk. If bankruptcy risk is systematic, one would expect a positive association between

bankruptcy risk and subsequent realized returns. However, results demonstrate

that bankruptcy risk is not rewarded by higher returns. Thus, a distress

factor is unlikely to account for the size and book-to-market effects. Surprisingly,

firms with high bankruptcy risk earn lower than average returns since 1980. A

risk-based explanation cannot fully explain the anomalous evidence.

SEVERAL STUDIES SUGGEST that the effects of firm size and book-to-market,

probably the two most powerful predictors of stock returns, could be related

to some sort of a firm distress risk factor. For example, Chan and Chen

~1991! find that "marginal" firms, or inefficient firms with high leverage

and cash flow problems, seem to drive the small firm effect. Fama and French

~1992! conjecture that the book-to-market effect might be due to the risk of

distress. Chan, Chen, and Hsieh ~1985! show that much of the size effect is

explained by a default factor, computed as the difference between high-grade

and low-grade bond returns. Fama and French ~1993! and Chen, Roll, and

Ross ~1986! find that a similarly defined default factor is significant in explaining

stock returns.

This study investigates the importance of the firm distress risk factor and

its relation to size and book-to-market effects. Probability of bankruptcy is a

natural proxy for firm distress, and there is a well-developed literature on

bankruptcy prediction that provides powerful measures of ex ante bankruptcy

risk ~see Altman ~1993! for a review!. Evidence that bankruptcy risk

is systematic would support a distress factor explanation for the size and the

book-to-market effects.

Existing evidence on the relation of bankruptcy risk to systematic risk is

mostly circumstantial and often contradictory. Lang and Stulz ~1992! and

Denis and Denis ~1995! demonstrate that bankruptcy risk is related to aggregate

factors, which implies that bankruptcy risk could be positively related to systematic risk. Shumway ~1996! finds that NYSE and AMEX firms with

high risk of exchange delisting for performance reasons earn higher than

average returns, suggesting that the risk of default is systematic. However,

Opler and Titman ~1994! and Asquith, Gertner, and Sharfstein ~1994! find

that bankruptcy is mostly due to idiosyncratic factors, which suggests that

bankruptcy risk is unrelated to systematic risk. Interestingly, Altman ~1993!

finds that the bonds of the most distressed firms ~defined as high-yielding

bonds! earn lower than average subsequent returns, consistent with bankruptcy

risk being negatively related to systematic risk.

This study presents more direct and comprehensive evidence about the

relation between bankruptcy risk and systematic risk. Measures of bankruptcy

risk are derived from existing models of bankruptcy prediction ~Altman

~1968! and Ohlson ~1980!! which have been widely used in other research

and in practice. Systematic risk is proxied by subsequent realized returns.

As hypothesized in other studies, simple correlations reveal that bankruptcy

risk is negatively related to firm size and positively related to book-to-market.

Thus, bankruptcy risk could potentially account for the size and the book-tomarket

effects if bankruptcy risk is a systematic risk priced into returns.

However, a further investigation reveals several findings that are inconsistent

with a distress explanation for the size and the book-to-market effects.

First, the main result of this study is that bankruptcy risk is not

rewarded by higher returns. Surprisingly, firms with high bankruptcy risk

earn significantly lower than average returns since 1980.1 Second, the relation

between bankruptcy risk and book-to-market is not monotonic: distressed

firms generally have high book-to-market but the most distressed

firms have lower book-to-market. Thus, a return premium related to bankruptcy

risk cannot fully explain the book-to-market effect even if distress

were rewarded by higher returns. Third, this study finds that the size effect,

strong in the 1960s and 1970s, has virtually disappeared since 1980 ~see

also Fama and French ~1992! and Roll ~1995!!. Although the disappearance

of the size effect is somewhat of a puzzle, pre-1980 evidence suggests that

there is no reliable relation between bankruptcy risk and returns that could