Swedroe: Default Risk Doesn’t Pay

December 07, 2015

There are many well-documented anomalies in finance. Among them is the surprisingly small return that investors historically have earned for taking credit risk in fixed-income markets—the default premium, as measured by the difference in returns between long-term Treasurys and long-term corporate bonds, has been only about 0.3%—and that stocks with a higher risk of defaulting on debt have produced lower returns.

Chris Godfrey and Chris Brooks—authors of a September 2015 paper, “The Negative Credit Risk Premium Puzzle: A Limits to Arbitrage Story”—contribute to the literature and our understanding of why this anomaly persists.

Reasons Behind An Anomaly

The explanation lies not only in investor behavior—specifically, a preference for lottery-ticketlike positive skewness (the small probability of winning big)—but also in the well-documented limits to arbitrage, which prevent arbitrageurs from correcting mispricings.

Stocks with high credit risk tend to be stocks with the following characteristics: high idiosyncratic volatility, high illiquidity, wide bid/ask spreads and low turnover. These traits hinder the ability of arbitrageurs to correct overpricing because they increase costs and create incremental risks. For example, if a stock is illiquid with low turnover, arbitrage is more difficult, because these properties increase the time it takes for an arbitrageur to enter or exit a position in size.

It’s important to understand that arbitrage is more likely to be constrained on the side of the trade requiring a short sale. This occurs because selling a share short requires that the share be borrowed from a willing counterparty, and the facility for stock lending in sufficient size could be limited. “Lottery ticket” stocks tend to be under-owned by institutional investors, who are the traditional lenders of equities (which allows for shorting).

The limited supply, which drives up the cost of borrowing shares (the short-seller pays a borrowing fee), also limits the ability of arbitrageurs to correct mispricings. Thus, more optimistic investors are able to impact an asset’s price better than those with more pessimistic views. The net effect of the difficulty of shorting relative to a long position is that overpricing is more prevalent. Thus, stocks can remain persistently overpriced, and therefore suffer low returns.

The Disposition Effect

Godfrey and Brooks provide another insight into how overpricing can develop from what is known as the “disposition effect.” They explain: “Disposition investors are those subject to the behavioural bias of the disposition effect …. One of the central predictions of the disposition effect is that such investors will tend to ride losses but sell gains preferentially …. Where disposition investors own a Winner stock, they will tend to increase selling pressure in the stock, as they attempt to lock in a sure gain; conversely, where they own a Loser stock, they will tend to decrease selling pressure in the stock, as they preferentially retain the stock, hoping to ride out their losses. Where limits-to-arbitrage factors frustrate the actions of arbitrageurs in correcting such overpricing, we should expect that disposition investors will cause Loser stocks to become overpriced, and that this overpricing will increase with the proportion the stock’s owned by disposition investors.”

They then suggest that “one reason high credit risk Loser stocks become overpriced in the first place is that high credit risk stocks are owned disproportionately by disposition investors.”


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