Pricing Default Risk: The Good, The Bad, and The Anomaly

While the empirical literature has often documented a “default anomaly”, i.e. a negative relation between default risk and stock returns, standard theory suggests that default risk should be priced in the cross-section. In this paper, we provide an explanation for this apparent puzzle using a new approach. First we calculate monthly physical probabilities of default (PDs) for a large sample of European firms. Second we decompose these estimated PDs into systematic and idiosyncratic components; we measure the systematic part as the sensitivity of the physical PD to an aggregate measure of default risk. While sorting stocks based on physical PDs confirms a possible default anomaly, we find that the relation between the systematic default risk and stock returns is in fact positive. Our results therefore suggest that risker stocks, as measured by the physical PDs, will tend to underperform because they have on average lower exposures to aggregate default risk. Their riskiness is mostly idiosyncratic and can be diversified away.