Industry Distress Anomaly

Abstract

This paper offers a risk-based explanation for the financial distress anomaly across industries. We develop a dynamic model of long-term defaultable debt that incorporates a supergame of strategic competition and time-varying discount rates. The model implies a competition-distress feedback effect within industries, which amplifies the exposure of industries' profit margins and equity returns to aggregate discount-rate shocks. Industries with higher idiosyncratic left-tail risks are more distressed, yet are endogenously less exposed to aggregate shocks due to the weaker competition-distress feedback, implying lower expected equity returns. The interaction between competition-distress feedback, idiosyncratic left-tail risk, and exposure to discount-rate shocks at the industry level enables the model to quantitatively rationalize the industry distress anomaly.

Keywords: Stock and Bond Returns, Supergames, Tacit Collusion, Financial Distress Anomaly (JEL: G12, L13, O33, C73)

JEL Classification: G12, L13, O33, C73