Swedroe: Default Risk Doesn’t Pay

December 07, 2015

  • High credit risk stocks are held disproportionately by disposition investors.
  • High credit risk stocks have significantly higher levels of idiosyncratic risk than low credit risk stocks.
  • Loser stocks have significantly higher idiosyncratic risk than winner stocks.
  • The negative credit spread anomaly turns out to be a story about the apparently unexplained underperformance of high credit risk, extreme loser stocks.
  • High credit risk stocks have higher levels of illiquidity than low credit risk stocks, and loser stocks are significantly more illiquid than winner stocks.
  • High credit risk stocks have significantly lower turnover than low credit risk stocks.
  • High credit risk stocks have significantly wider spreads than low credit risk stocks and loser stocks have significantly wider spreads than winner stocks.
  • The measure of illiquidity is significantly negatively priced, with less illiquid stocks earning higher ex-post returns than more illiquid stocks. That’s in line with what would be expected if it were acting as a limit to arbitrage, preventing overvalued, illiquid stocks from being shorted down to fair value. Similarly, the bid/ask spread has a significantly negative price. Stocks with wider spreads have lower returns than stocks with narrower spreads. And, in line with the limits-to-arbitrage story, high-turnover stocks earn higher returns than low-turnover stocks.
  • The book-to-market premium is most significant where limits-to-arbitrage factors are more severe.
  • The negative credit spread is only significant where arbitrage is most constrained. In other words, the negative credit spread is only significant for the decile of widest credit risk, lowest turnover, highest illiquidity and smallest size.

Another interesting finding of the study was that high credit risk stocks are not smaller than low credit stocks, showing that firms do not have high credit risk simply because they are small.


The negative cross-sectional pricing of credit risk in equities has been a persistent anomaly within the traditional asset pricing literature. The field of behavioral finance provides us with a helpful explanation for the anomaly—the disposition effect. And the evidence shows the risk and real-world costs of implementing arbitrage strategies that would prevent mispricings from occurring serve to create hurdles that allow for mispricings to persist.

Godfrey and Brooks summarize their findings this way: “Idiosyncratic volatility, illiquidity, turnover and average spread behave as a limits-to-arbitrage explanation would predict.” They concluded that their research provided “a parsimonious explanation of the outstanding anomaly of the negative pricing of credit risk among equities.”

Their conclusion follows closely the conclusions from the aforementioned paper, “Leverage Aversion and Risk Parity.” It’s not only about leverage aversion, but also about the factors that make leverage harder and/or more expensive to implement.

For investors, the implications are striking. If you want or need higher expected returns from your portfolio, you shouldn’t go seeking those higher expected returns from the default premium. Instead, consider looking for ways to increase your exposure to the factors that show persistent and pervasive premiums.

This means the premium should be robust (they hold for various definitions) and have a logical explanation for why it should be expected to persist. The factors that meet these criteria are limited and include: beta, size, value, momentum, profitability/quality and term.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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