A Resolution of the Distress Risk and Leverage Puzzles in the Cross Section of Stock Returns

Thomas J. George e-mail:tom-george@uh.edu C. T. Bauer College of Business University of Houston Houston, TX 77240

and Chuan-Yang Hwang e-mail:cyhwang@ntu.edu.sg Division of Banking and Finance Nanyang Business School Nanyang Technological University Singapore 639798

April 2009

Acknowledgments: We are grateful to David Bates, Alex Boulatov, Gerry Garvey, Rick Green, Bing Han, Praveen Kumar, Scott Richardson, Tom Rourke, Mike Stutzer, Sheridan Titman, Stuart Turnbull, Toni Whited, Huai Zhang, an anonymous referee and participants at the Western Finance Association and China International Conferences for helpful comments and discussions. George acknowledges research support from the C.T. Bauer Professorship.

A Resolution of the Distress Risk and Leverage Puzzles in the Cross Section of Stock Returns Abstract We revisit findings that returns are negatively related to financial distress intensity and leverage. These are puzzles under frictionless capital markets assumptions, but consistent with optimizing firms that differ in their exposure to financial distress costs. Firms with high costs choose low leverage to avoid distress, but retain exposure to the systematic risk of bearing such costs in low states. Empirical results are consistent with this explanation. The return premiums to low leverage and low distress are significant in raw returns, and even stronger in risk-adjusted returns. When in distress, low leverage firms suffer more than high leverage firms as measured by a deterioration in accounting operating performance and heightened exposure to systematic risk. The connection between return premiums and distress costs is apparent in subperiod evidence—both are small or insignificant prior to 1980 and larger and significant thereafter.

Introduction
Fama and French (1993)