Recovery Risk in Stock Returns

In this paper we argue that book-to-market and size attributes represent sensitivities of firm returns to several risk factors, and in so doing they subsume the information in other attributes. Although this gives them high cross-sectional explanatory power, they are not very indicative if we are concerned with testing whether an individual risk factor is priced. In that regard, claiming that financial distress is not priced, by only considering probability of bankruptcy, seems premature. Rational investors may also care about recovery rates and the relatively higher mean returns observed for small firms with very low book-to-market ratios is consistent with this view. To analyse recovery risk, we construct mimicking portfolios by sorting stocks on less noisy attributes such as fixed-assets and intangible-assets ratios. We find that recovery risk mimicking portfolios exhibit typical risk factor characteristics, and perform well in explaining the cross-section of returns. The results suggest that recovery risk factor is a good candidate to be priced, and much of the explanatory power of the size attribute comes from the fact that it embodies useful information regarding recovery risk. Overall, our findings have important portfolio management implications.