The Real Side of Financial Distress

The credit risk puzzle, wherein high credit risk assets earn lower returns than their low credit risk counterparts, is driven by investors' slow reaction to the adverse real effects of financial distress. Evidence from stocks and corporate bonds challenges explanations based on shareholders' ability to extract value from bondholders during bankruptcy, conditional risk-based asset pricing models, or lottery-type preferences. Customers, suppliers, investors, and creditors distance themselves from distressed firms. Distressed firms experience deteriorating fundamentals and, in turn, reduce advertising, capital expenditures, and R&D, thereby further hampering future profitability and growth prospects.