The Distress Anomaly is Deeper than You Think: Evidence from Stocks and Bonds

Abstract The distress anomaly reflects the abnormally low returns of high credit risk stocks during financial distress. Evidence from stocks and corporate bonds reinforces the anomaly and challenges rationales based on shareholders’ ability to extract value from bondholders, time-varying betas, lottery-type preferences, biased earnings expectations, and limits-to-arbitrage. Moreover, mispricing of distressed stocks and bonds is associated with excess investment and excess external financing. Potential real distortions are materially understated when assessed based only on equity mispricing. We emphasize the important role of corporate bonds in dissecting the distress anomaly, and show that the anomaly is an unresolved puzzle.