Distress Risk Premia in Stock and Bond Returns

Abstract

This paper investigates whether the potential for rent extraction due to shareholders' strategic actions is reflected ex ante in stock and bond prices based on a joint study of stock and bond markets. I document that higher default probabilities are associated with higher yield spreads and bond returns but not with higher stock returns. Shareholder advantage has no significant effect on distress risk premia in stock or bond returns for firms with bonds outstanding. I also find that the negative relationship between distress risk and stock returns is more evident for firms with high trading cost and arbitrage risk. My findings suggest that the stock market, but not the bond market, misprices distress risk.