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Bankruptcy Prediction Models and the Cost of Debt ♣

Sattar A. Mansi, William F. Maxwell, and Andrew Zhang∗
June 8, 2010 Abstract
Financial institutions and academic researchers utilize bankruptcy prediction models to assess distress risk. However, predicting default can be problematic since (i) few firms actually experience default in any one year, (ii) the lag between practical and actual default can vary significantly, (iii) firms can strategically default, (iv) firms can rework their obligations outside of bankruptcy, and (v) default frequency varies significantly over economic life cycles. Thus, relying on bankruptcy data alone to calibrate and validate these models can be problematic. We take a simpler approach by relying on the firm’s cost of debt as a market proxy for distress risk. We then assess the validity of four widely used bankruptcy models including two accounting-based models (Altman’s, 1968; Ohlson’s, 1980), one reduced form model (Campbell, Hilscher, and Szilagyi, 2010) and one structural distance to default model (Merton, 1974). We find dramatically different assessment of risk based on the models used. The Campbell, Hilscher, and Szilagyi (2010) model has the most explanatory power on the cost of debt followed by the Merton model. The accounting based approaches of Altman (1968)’s Z-Score and Ohlson (1980)’s O-Score are highly ineffective. We caution researchers when using Zand O-Scores and recommend the use of Campbell, Hilscher, and Szilagyi model to measure distress risk. We also demonstrate the problems of not controlling for industry and time variation in any of these measures. Keywords: Bankruptcy prediction models, cost of debt financing, distress risk JEL Classification: C52; G13; G33; M41

Mansi is an Associate Professor of Finance at Virginia Tech, Maxwell is a Chaired Professor of Finance at Southern Methodist University, and Andrew (Jianzhong) Zhang is an Assistant Professor of Finance at the University of Nevada, Las Vegas. All remaining errors are ours.

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1. Introduction The goal of financial distress models is to utilize information about the firm to construct a single variable allowing for the comparison of default risk across firms. The literature on financial distress risk provides four main models that forecast default including two accounting-based models (Altman, 1968; Ohlson’s, 1980), one reduced form model (Campbell, Hilscher, and Szilagyi, 2010) and one structural model (Merton, 1974). These models lead to four proxy variables, namely, Altman’s Z-Score, Ohlson’s O-Score, CHS Score, and Merton’s Distance to Default (Merton-DD). These measures are widely used in the literature to proxy for distress risk, especially in the areas of accounting and financial economics. According to Social Sciences Citation Index, as of December 2009, Altman (1968), Ohlson (1980), Merton (1974), and Campbell et al. (2010) have been cited 691, 295, 709, and 9 times respectively 1 Based solely on citations, the z-score and o-score remain highly popular distress risk measure in the academic literature, as they were 132 and 59 times in 2009 alone. Our results suggest that this is highly problematic. We find evidence suggesting that the Altman and Ohlson model are very weakly related to distress risk and in fact do no better than a naive distress measure, the leverage ratio. Given that empirical results differs based on the default measure utilized, the relative performance of these models in forecasting financial failures is of significant concern in the literature. 2 While the results are mixed, extant studies have never researched these four distress measures all together in a unified and comprehensive framework. Also ignored is the relative performance of these measures across different economic periods. Lastly, the relation between default measures and group of firms characterized by some important firm-specific variables like size, book-to-market ratio, and volatility has not been analyzed.

These variables

We conduct a short and likely incomplete survey by only considering papers recently published in top accounting and financing journals as of the year 2009. 2 For example, Agarwal and Taffler (2008) find the outperformance of Z-Score over Merton-DD. Hillegeist, Keating, Cram, and Lundstedt (2004) find that Merton-DD provides more information than either Z- or O-Score. Kealhofer and Kurbat (2001) argue that Merton-DD captures all of the information in bond ratings and well-known accounting variables. Beaver McNichols, and Rhie (2005) use a logit model with a longer time period finds that the ability of accounting ratios to predict bankruptcy remains. Duffie, Saita, and Wang (2007) show that Merton-DD has significant predictive power in a model of default probabilities over time. Shumway (2001) argues the advantage of a hazard model over the econometrical models underlying Altman’s Z-Score and Ohlson’ O-Scores and the better performance of market-based variables over accounting-based variables. Bharath and Shumway (2008) find that one can easily construct a reduced form model that outperforms Merton-DD in out-of-sample forecasting ability, but hazard models that use the Merton-DD probability with other covariates have slightly better performance than models that omit the Merton-DD probability. Campbell et al (2010) find that adding Merton-DD to their reduced form model does not increase adjusted R-squared of their logit regression, and conclude that CHS model outperforms Merton-DD in bankruptcy forecasting.

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significantly reflect the changes in corporate capital structure and the riskiness of corporate activity. According to Campbell et al. (2010), these changes can partially explain the changes in financial failures through time. As a result, to locate a distress measure that has robust superior forecasting power of bankruptcy is crucial to many empirical studies. Our results find a very significant difference across these models with accounting based measure faring poorly. In this paper, we attempt to reconcile the differences in extant studies by examining the relation between financial distress measures and bond spreads, an assessment of the markets' perception of risk, to determine the relative performance of these models. Given that bond investors require stable cash flows and demand default risk premium in yield spreads, many studies have related yield spreads to distress risk from various perspectives (see e.g., Almeida and Philippon, 2007; Anginer and Yildizhan, 2010; Bharath and Shumway, 2008; Davydendo and Strebulaev, 2007). We posit that distress risk is efficiently impounded in bond market prices; therefore, yield spreads are a significant reflection of the probability of financial failure. Hence, we are not modeling actual default risk as in prior research, but instead analyzing the ability of default models to capture market based distress risk. Our results indicate that the CHS Score is a superior forecasting model followed by Merton-DD, O-Score, and Z-Score. This is true in both early and late periods, and across normal and shock economic periods. The outperformance of CHS is more evident for firms with small size, low M/B ratio, and high equity volatility. To assess the relative performance of different models in forecasting financial failure, prior studies use prediction-oriented tests to distinguish between alternative models (see for example, Shumway, 2001; Bharath and Shumway, 2008). These tests usually rank sample firms by each measure into deciles (or quintiles) and assess prediction accuracy within a particular (typically one-year) time-horizon for each decile, either in-the-sample or out-of-sample. The model with the highest overall prediction accuracy is deemed the best. Hillegeist et al. (2004) argues that whether or not a single firm declares bankruptcy ex post does not provide evidence about whether the ex ante estimate is an accurate reflection of the true probability. They propose relative information content tests to compare the amount of distress-related information contained in each measure. Statistically, however, either test may have a relatively low test of power because the size of distressed sample is usually very small. For example, financial


equity and debt holders have to assess the distress risk on a continuous basis to determine the required cost 4 . usually are also predictive variables in the distress measures (see Hotchkiss. firms often become financially distressed either much earlier or later than the actual default or bankruptcy filing date. and Thorburn. Some important distress signals like dividend cut or omission have never been counted. For example. 2010). Specifically. and thus capture more early distress information than the others. a firm may have market assets greater than total liability but does not have enough cash and liquid assets to meet its current obligations and is forced to bankruptcy. In practice. where a firm enters into the sample upon occurrence of one or more of the following events: default in payment of interest or principal. and cash flows to meet debt covenants and interest payment to delay default or bankruptcy. a decision-maker will more typically make a continuous decision choice (Hillegeist et al. Additionally. These studies are usually different in their definition of financial distress and hence the sample construction of distressed firms. previous studies when examining relative performance of distress models typically presume a dichotomous decision context. 2004). On the other hand. announcement of bankruptcy. Strategic default brings firms into default “early” to break unfavorable contracts and obtain forced debt concessions. or being delisted from exchanges for financial problems. testing results are usually sample-specific and may be sensitive to sample size and sample period used in their model estimations. working capital. Mooradian. 2008). some firms will file for bankruptcy even when they are economically solvent. these studies conduct tests based on a sample of distressed firms. These firms would not show up in the sample of defaults. Even more importantly. such as firm size and M/B ratios. As a result. Additionally. A comparison between alternative bankruptcy forecasting models might be misleading when one measure of distress is timelier. and even more problematic is that the characteristics related to firms choosing to restructure inside or outside of bankruptcy.failures were extremely rare until the late 1960s.. John. some financially distressed firms can manage its operating earnings. however. however. we know that many firms restructure their debt before entering bankruptcy. and in the 3 years (1967 to 1969). These studies also suffer from problems in defining financial failure and constructing distressed sample.. Further. there were no bankruptcies at all (Campbell et al. and that lag or lead time can be significant.

2. we use offering amount. We also follow Franzen. Extant studies suggest that the underperformance of accounting-based Z.and O-Scores might be due to the staleness of parameters and failure to accounting for R&D effects in their predictive variables. credit ratings from Moody’s and S&P. Data and Variable Measurement 2. these two scores continue to have poor performance. corporate bond spreads will provide a consistent and comprehensive benchmark for the assessment of the relative performance of different distress measures without the need of the sample construction of distressed firms. but also a timely and continuous one. These include: (i) Lehman Brothers Fixed Income (LBFI) database for debt data. and control variables. and find the relative outperformance of CHS remains intact. O-Score and Z--Scores. and quote. and Simin (2007) and re-construct these two scores by accounting for R&D effects. before and after controlling for years to maturity and industry effect. bond age. Section 2 describes data. and coupon rate to control for liquidity and tax effect. yield.and O-Scores. coupon. issue. and maturity dates on 5 . Using a large sample of bond data from the Lehman Brothers Fixed Income database covering the period from 1980 through 2006. we find that the four measures of financial distress are significantly related to bond spreads with CHS Score obtaining the highest t-statistic and adjusted R-squared followed by Merton-DD. However. distress measures. we focus on the corporate bond spread since it is extracted based on publicly traded debt and represents not only a sensitive measure of distress risk. Consequently.of capital. Rodgers. Section 4 discusses and concludes. Section 3 explains methodology and discusses the empirical results. (2004) to construct updated Z. duration. and (iii) Center of Research in Security Prices database for security returns. callability. The remainder of the paper is organized as follows. (ii) Compustat Industrial Annual and Quarterly database for financial information. Since it is well known that corporate spread is too high to be explained only by expected default. We use updated coefficients from Hillegeist et al.1 Data Description We utilize three databases in our analysis of the impact of bankruptcy prediction models on the cost of debt financing. The LBFI database contain month-end security specific information such as bid price. In this study.

Since some constituents of O. defined as the sum of current long-term debt (annual item 34) and long-term debt (annual item 9) divided by market firm value (sum of current long-term debt (annual item 34). Altman (1968) Z-Score and Ohlson (1980) O-Score. We lag four months 3 Though not reported. Mansi.scores are not available in the Compustat quarterly tape. In addition. 2005).g.nonconvertible bonds that are used in the Lehman Brothers Bond Indexes. long-term debt (annual item 9). 2.and Z. We further eliminate all corporate floating rate debt. and bonds with less than one year to maturity due to their illiquidity. since some financial ratios used to construct distress measures are not applicable and have different meanings in these industries. The database is commonly used in the finance literature (e. and Wald. firms must have a debt issue that is present in the LBFI dataset and financial information must also be available in the Compustat and CRSP databases to compute all four distress measures (described in detail below). 3 We follow the convention in the literature to exclude regulated utilities with SIC codes 4949 to 4999 and financial firms with SIC codes 6000 to 6999.608 monthly observations on 1. Maxwell. This serves as baseline to compare the effectiveness of the models. For a firm-year observation to be included in the analysis. The first two models. 2009.752 firms covering the period from 1980 through 2006.. 6 . are based on accounting data. we only include the bond with the greatest term to maturity since it is more representative of the cost of debt. Bharath and Shumway. Merging the databases and applying these requirements yields a data set of 120. and market equity (product of annual item 199 and item 25). and Maxwell. the market leverage ratio of the firm.2 Measuring Bankruptcy Prediction Models We use four basic models along with derivations of the accounting models to measure distress risk. 2008. Similar to Bharath and Shumway (2008) and Campbell and Taksler (2003) we also exclude all AAA rated bonds because the data for these bonds may not be reliable. Klock. we also include in the analysis a naive benchmark. we obtain similar results using the average spread across multiple issues for these firms. bonds with an odd frequency of coupon payments. we follow the convention in the literature and use Compustat annual tape to construct these two accounting-based measures and update them annually. For firms with multiple issues. inflation-indexed bonds. Mansi.

0. intwo is a dummy variable that equals to 1 if the firm has negative book equity.2 times the sum of the previous 5 years of R&D allow accounting information from annual filing to be available to bond investors when constructing these two measures.285*intwo . reta is retained earnings (annual item 36) scaled by total assets (annual item 6). Franzen. or current assets (annual item 4) minus current liability (annual item 5) scaled by total assets (annual item 6).521*chin (2) where asset is the log of total assets (annual item 6).32 . If net income (annual item 172) is positive.1. Rodgers.1. the effectiveness of these two accounting-based variables has deteriorated to the detriment of inferences related to distress risk. and Simin (2007) argue that since reporting of research and development (R&D) spending has increased over time. nita is net income (annual item 172) divided by total assets (annual item 6).407*asset + 6. 0 if missing) minus R&D amortization defined as 0. Therefore.0. ffotl is fund from operations defined as pretax income (annual item 170) plus depreciation (annual item 14) divided by total liability (annual item 181). The primary specification for the z-score model is Z-Score=-1.43*wcta + 0.83*ffotl + 0.60*mvliab-sata (1) where wcta is working capital.2. we reverse the signs of original coefficients so the Z-Score is increasing in the probability of bankruptcy. mvliab is market value of equity (annual item 199 times item 25) divided by total liability (annual item 181). ebitta is earnings before interest and tax (annual item 170 plus item 15) divided by total assets (annual item 6). wcta is working capital to total assets (as defined in equation (1) above).03*tlta .37*nita . And the primary specification for the O score model is O-Score = -1. we further control for the tax effect 7 .72*oeneg . we modify the definition of constituent variables to control for the effect of accounting for R&D. For comparison with other models.0757*clca .2*wcta-1. and sata is sales (annual item 12) divided by total assets (annual item 6). clca is current liability (annual item 5) divided by current assets (annual item 4). Adjusted net income is the sum of net income (annual item 172) plus R&D expense (annual item 46.4*reta-3. chin is change in net income (annual item 172) from prior year divided by the sum of absolute values of current and prior year net income.1. tlta is total liabilities (annual item 181) divided by total assets (annual item 6).3*ebitta-0.

22mvliab+0. T.08*tlta + 0.01*intwo + 1.04*reta-0.and O-Scores. The third measure of distress risk is based on the structural model of Merton (1974). or BD. and construct an updated Z-Score and O-Score measures. where the tax rate is defined as the appropriate annual statutory tax rate: 46% in the period 1980-1986.04*asset + 0. total assets. we re-construct all constituent variables in Z. Hillegeist et al. scaled by the standard deviation of the firm’s asset value (SIGMA). In this system. Hillegeist et al.and O-Scores respectively and apply the original coefficients to these variables to construct a new set of rate). We lag two months to allow the most recent accounting information from quarterly filings to be available to bond investors when we construct the DD measure. and Campbell et al. If net income (annual item 172) is positive. We use an iterative procedure by solving a system of two nonlinear equations simultaneously to estimate asset value and asset volatility.20*nita + 0.1. labeled hereafter as adjusted Z-Score and Adjusted O-Score. equal to 1 year.18*ffotl + 0.01*clca + 1.10*chin (4) (3) where all constituent variables are defined in the same manner as in the original model without adjustment for the R&D effect. 40% in the year 1987. That is Updated Z-Score=-4. a measure of the difference between the asset value of the firm (TA) and the face value of its debt (BD). 2004).g. (2004).08 wcta+0.1*ebitta-0.06sata Updated O-Score = -5. and Watts.8*RDt-1+0.4*RDt-3+0. 1996. equity is valued as a European call option on the value of the firm’s assets with time to maturity. we use the coefficients based on the re-estimation by Hillegeist et al. 34% in 1988-1992. Bharath and Shumway (2008). This convention is 8 . Several studies have argued that the original coefficients in each model have substantially changed from their original values (e.6* multiplying the adjusted net income by (1 . and 35% in 1993-2006.. Therefore. The variable adjust total assets is total assets plus R&D capital defined as RD+0. Begley.59*oeneg .91 + 0. and total liability. After adjusting net income.2*RDt-4. Specifically. we adjust total liability as total liability (annual item 181) plus deferred tax liability defined as R&D capital times the tax rate. (2010) estimates the Merton (1974) model to obtain the distance to default (DD). Recently.34-0.01*wcta-0. Ming. we use short-term (quarterly item 45) plus one half long term (quarterly item 51) book debt to proxy for the face value of debt.

13*cashmta + 0. (2010) reduced form model. We use a 12-month rolling window (with at least 50 observations) standard deviation of daily stock return to measure equity volatility and use it as the starting value of asset volatility. Before calculating asset value and volatility.26*nimtaavg + 1. we align each company’s fiscal year appropriately with the calendar year.42*tlmta .13*exretavg + 1. where now we calculate the median only for small but nonzero values of BD (0 < BD <0. (2010). This adjustment ensures that the accounting data are available at the beginning of the month over which bankruptcy is measured.06 as an empirical proxy for the equity premium. As before. converting Compustat fiscal year quarterly data to a calendar basis.a simply way to take account of the fact that long-term debt may not mature until after the horizon of the distance to default calculation.7. and then lag accounting data by 2 months. (2010) and use 0.0. This captures the fact that empirically. Finally. We use Compustat quarterly tape and CRSP monthly and daily tapes to compute the fitted values using the coefficients in the 3rd column in Table 4 of Campbell et al.058*price (6) 9 . we construct the CHS Score based on Campbell et al. Note that we put the negative sign before the traditional measure of distance to default so our DD is actually increasing in the probability of bankruptcy.01). we use BD= median (BD/TL)*TL.41*stdev . we use BD=median (BD/TL)*TL.045*rsize . We compute Merton’s distance to default.20. DD.5 and 99. SIGMA is asset volatility. Our primary specification is CHS Score = -9.2.075*mtb . Rbill is Treasure bill rate. where ME is market equity.0. where the median is calculated for the entire dataset and TL is the total liabilities (quarterly item 54). If book debt (BD) is missing. If BD=0. We follow Campbell et al.16 .5 percentiles of the crosssectional distribution.06 + Rbill − SIGMA 1 SIGMA 2 2 (5) where TA is total assets. we adjust BD so that BD/ (ME+BD) is winsorized at the 0. as DD = − − log( BD / TA) + 0. BD tends to be much smaller than TL.

Tlmta is the ratio of total liabilities (quarterly item 54) divided by the sum of market equity and total liabilities. with geometrically declining weights on lags. while DD and CHS Scores are updated monthly. When computing CHS Score. a proxy for liquidity position of the firm. The variable nimta is computed as net income (quarterly item 69) divided by the sum of market equity (the product of number of shares outstanding and month end stock prices. truncated above at the $15. As discussed before. We winsorize all eight predictive variables at the 5th and 95th percentiles of their pooled distributions. respectively. The moving average nimtaavg suggests that a long history of loss is a better predictor of bankruptcy than one large quarterly loss in a single month. We adjust book equity by adding 10% of the difference between market and book equity. both from CRSP) and total liability (quarterly item 54). When lagged exert or nimta is missing. we replace missing stdev observations with the cross-sectional mean of stdev.where nimtaavg and exretavg are the moving average of lagged four quarterly nimta and 12 monthly exret. Stdev is the annualized three-month rolling sample standard deviation. 10 . where book equity is the sum of stockholders’ equity (quarterly item 60) and deferred tax credit (quarterly item 52) minus preferred stockholders’ equity (quarterly item 55). The moving average exretavg suggests that a sustained decline in stock market value is a better predictor of bankruptcy than a sudden drop in stock price in a single month. we code stdev as missing if there are fewer than five nonzero observations over the three months used in the rolling window computation. all Z. Cashmta.2 and 3. we replace it with the cross-sectional mean in order to avoid losing observations. We expect the difference in updating frequency will affect the relative performance of these measures in forecasting bankruptcy and predicting bond yield spreads and conduct the robustness check based on annual data in Sections 3.3 below. Price is the log price per share. Rsize is the relative size of each firm measured as the log ratio of its market equity to that of the S&P 500 index. In calculating summary statistics and conducting regression analysis. Mtb is the ratio of market-to-book equity. is the ratio of cash and short term investments (quarterly item 36) divided by the sum of market equity and total liabilities. we winsorize all distress measures at the 1st and 99th percentiles to further limit the influence of outliers.and O-Scores are updated annually. To eliminate cases in which few observations are available. Exret is the monthly log excess return on each firm’s equity relative to the S&P 500 index.

O-Score. -2. When utilizing the log of the yield spread. yield spread. Firms 11 . The mean.399. and 288 basis points (bps).75 billion.062. The median market-to-book ratio is 1. close to the mean of 1. Merton-DD.702. a standard deviation of $10.2. we use the log of bond yield spread instead of raw yield spread in our regressions. The yield to maturity on a Treasury security is the yield on the constant maturity series obtained from the Federal Reserve Bank in its H15 release based on a par bond. because the yield spread is highly skewed. and 25th and 75th percentile values of $560 million and $4. 2. In the cases where no corresponding Treasury yield is available for a given maturity. we rely on raw yield spread. The cost of debt. Our naïve measure and the four measures of financial distress risk market leverage. For some of our analysis. or yield spread. This is reasonable given that firms with bond issuances are much larger and financially healthier than firms in the CRSP-Compustat universal.481. the mean (median) market capitalization is $5. these numbers indicate that majority of our sample firms have low default probability. and standard deviation of the main variable in our analysis.4 Descriptive Statistics Panel A of Table 1 reports summary statistics for sample firms from 1980 to 2006.49. respectively. the yield spread is calculated using linear interpolation. The yield to maturity on a corporate bond is the discount rate that equates the present value of its future cash flows to its current price. As discussed before. respectively. [Insert Panel A of Table 1 about here] For the overall sample. is the difference between the yield to maturity on a corporate bond and the yield to maturity on its maturity equivalent Treasury security. we use the log transformed yield spread to approximate a normal distribution.057. 189. and -7.7) billion. But due to the skewness of the yield data. -6. is 283. we find a slightly higher r-squared in the regression results but our results are invariant when using raw yield spread. -1.0 ($1. respectively.87. median. Z-score.3 Measuring the Cost of Debt Financing We use the month-end bid price from the LBFI database to compute the cost of debt for each corporate bond.7 billion. with upper and lower quartile values of 341 and 119. and CHS Score have mean values of 0. Compared to summary statistics reported in other studies.

transportation and communication (22%). The pairwise correlation between any two measures of financial distress is also positive. The mean and median traded debt has maturity of 15 and 13 years BBB+.725). MTB. The yield spread is also negatively correlated with bond ratings. fishing. which indicates a large portion of the sample has slightly below average quality debt. wholesale and retail trade. evidence consistent with a general expectation that firms with higher distress measures and lower credit ratings have higher costs of debt financing. mining. and bond 12 . O-Score and CHS Score are positively correlated with MTB. services.368%. [Insert Panel B of Table 1 about here] Panel C of Table 1 provides the Pearson correlation between the variable used in the analysis and the four distress measures. For example. wholesale and retail trade (11%). with the highest correlation with CHS Score. on average. We find that yield spread to be positively correlated with market leverage and each of the four measures of financial distress. Based on the sample. indicating that these four measures may have captured different aspect of financial distress. This indicates that distress measures might have different significance for value and growth firms. forestry. with the highest correlation existing between Merton-DD and CHS Score (0. we also test the robustness of our results across firms that are different in size. while Z-Score and Merton-DD are negatively correlated with MTB. Panel B of Table 1 describes the industry distribution of the sample (in absolute number and in percentage) using the standard Security Industry Classification (SIC) codes. respectively. has been outstanding for about 3. with standard deviation ranging from B. For that reason. Different measures also have different correlations with certain firm. real estate. construction. Industries include agriculture. and public administration. services (10%). and mining and construction (9%).and bond-specific characteristics. a large portion is concentrated in manufacturing (about 47%). manufacturing (food through petroleum and plastics through electronics). In terms of debt variables. However. transportation and communications excluding the sample have average annualized daily volatility of stock return of 37%. the mean and median bond rating variable equates to S&P ratings of BB and BB-. volatility.1 years with coupon rate of 9. none of the correlation is close to a perfect correlation.

A possible criticism of the rating analysis is that while the results do not reflect any problems with the distress risk measures. Jostova.. market-tobook. Dhaliwal and Reynolds. For credit rating. We find that all distress measures are correctly aligned. 13 . We convert this information into major rating categories (AA. We report the median distress measure by rating category in the top row of each distress measure in Table 2.1 Distress Measures and Bond Ratings Some studies rely on bond ratings to assess financial distress (see e. Empirical Analysis 3..B). Chordia. Years to maturity is negatively correlated to yield spreads. 4 While bond ratings can clearly be erroneous measures of default risk. In this section. 2008. 1994). we examine how the distress measures are related to bond rating. For this reason. Except for Z-Score. we use the LBFI database to collect S&P bond credit ratings on a monthly basis and augment this dataset with Compustat data when available. we should see a correct alignment of the default risk measures. However. As a first condition. a lower distress scores should equate to a higher rating. and volatility as firms with bond ratings are larger with lower than average market-to-book ratios and market volatility. we examine the median distress measure by bond rating. To do this. they are known to be related to future default probability.27. years to maturity are negatively correlated with distress measures. poor performance of some distress measures based on the rating analysis is simply due to problems with the bond ratings. size. which is labeled All Periods. and as first attempt at examining the veracity of the distress measures. Avramov. [Insert Panel C of Table 1 about here] 3. Most problematic is the fact that firms with bond ratings have a selection bias on characteristics known to influence asset returns. bond ratings serve as one measures of risk and provide a starting point for our analysis.liquidity. The goal in this analysis is to see the relative spreads of the distress measure across bond ratings. with correlation coefficients between -0. and Philipov. we 4 We believe that relying on bond ratings should be avoided given the significant potential for a selection bias as firms with bond ratings are significantly different than the average public firm. we move to an analysis of credit spreads in the next section. indicating that bonds with longer years to maturity have higher liquidity and lower yield spreads. .24 to -0.g..

One measure of the usefulness of a distress variable is its stability across time and industry since researchers often compare the risk of firms at different points in time and across different industries. Across industries. the Wholesale and Retail for the Z-score. we examine how stable the relation is between the distress measures and bond ratings. but our results are generally similar when using the adjusted and updated measures. the median value of BB in one time period might in fact be rated a BBB or B in another time period. we hold time period constant in this analysis and only look at firms in the sample in June of 2006. we find that the distress measures are for the most part correctly aligned except for the Business Services industry with the Z. but it is clearly the most stable. As such. We do find some variation over time for the CHS Score. BB and B categories). We begin by examining the stability of the distress measures over time with the idea that a stable distress measure allows for comparison of firms across time. O-score and Merton-DD. and Communications for Market Leverage. All the other measures. Given our prior analysis. we next look at the comparability of distress measures across industries. [Insert Table 2 about here] In Table 3. whether they are stable over time. Z-score. As it relates to the stability of ranking over time.only focus on the originally constructed Z. and across industries. The results are presented in Table 2. Within industries. we compute the distress measures for the sample over three-year horizons and report the median levels within bond ratings.and O-score. The CHS Score varies across industries but the biggest discrepancy is less than the other distress measures. Overall. That is. there is a huge variation as firms would be rated BBB or B with the same distress score depending on industry for the Z-score. O-score and Merton model (the Z-score has the greatest variation). the distress measures mapping into bond ratings 14 . We examine whether the distress measures and bond rating correctly align over shorter-time frames. Market leverage does not correctly align with bond ratings in two of the nine periods in the BBB thru B categories. correctly align with rankings in sub-time periods. Hence. we find significant variation of rankings for market leverage. The Z-score is highly problematic as the distress measure does not correctly align in six of the nine time periods (the relative rankings across the BBB.and O-score.

From the analysis. in general. we do a double sort.and O-score models do not correctly distinguishing between the risks across the middle deciles. We sort into deciles based on the default measure and also on credit spreads. we examine the likelihood that the default score sorts the firms into a similar decile based on measuring credit risk with spreads. it should differentiate the relative riskiness of firms. [Insert Table 3 about here] This is 3. all models correctly distinguish the firms in the most extreme deciles. We begin with the assumption that for a distress measures to be an informative tool.2 Decile Sorts Noting the limitation of assuming that bond ratings are an accurate proxy for default risk. The results suggest that.suggests that it is difficult to have useful comparisons across time and industry. We then examine what percentages of firms in the default measure decile are also in the same or the adjacent decile based on the credit spread sorting. the Z. Both the Merton DD and CHS distress models correctly align firms within deciles to credit spreads. spreads are increasing with the deciles. Panel A of Table 4 provides analysis by examining the mean and median credit spread within distress measure deciles for a fixed time period (as of June 2006). market leverage. The Z and O-Score results are similar to the naive model. We begin our analysis by sorting firms into distress deciles based on the different distress measures. That is. [Insert Panel A of Table 4 about here] Next. Credit spreads are assumed to reflect the market’s perception of default risk plus a liquidity component. we find that market 15 . This sort is performed in June of every year and the results are reported in Panel B of Table 4. we should see credit spreads increasing across deciles. especially true for the Z-Score and less so for the CHS Score. We can classify a distress measure as being a more accurate depiction of market risk if there is a higher percentage in each decile. If the distress measure is properly capturing risk. we move to examine the relation between distress measures and credit spreads. In contrast.

at month t+1. we find very little difference between the market leverage and the O-Score in performance.t+1 = β0 + β1(Distress Measure)i. [Insert Panel B of Table 4 about here] As an overall conclusion to the decile analysis. the R&D adjusted Z. Hence for brevity. All of our tests are predictive in nature. 3.leverage does a better job in every decile when compared to the Z. Time-to-Maturity is the maturity of the firm's bond. Our primary regression model is Spreadi. On aggregate. is a vector of factor sensitivities for control variables. and the updated Z and O-score models seem to do a particularly poor job of assessing risk.and O-Score don't really change these conclusions. and λi. If anything the Z-score seems to perform worse than market leverage. we conduct cross-sectional regressions of spread relative to the distress measures.t+1 is the log yield spread for firm i. we focus solely on the original Z. in the remainder of the paper we find similar results for the R&D adjusted and updated Z and O-score models. The R&D adjusted models in aggregate produce similar results to the original models. We construct distress measures using publicly available stock and accounting information over one period of time. Across all the measures.t (7) where Spreadi. Both the Merton DD and CHS do better on average than market leverage.and O-score models. the extremes are more easily differentiated than the middle deciles. and the updated models perform worse than the original models.t + β2(Time-to-Maturity) + λi(Controls)t +e i.3 Distress Measures & Credit Spreads a Regression Analysis To assess the effect of distress measures on yield spread. and evaluate whether these measures are associated with bond yield or change in bond yield in 16 . which includes time to maturity and industry dummies defined at one-digit SIC codes.and that the O-Score seems to do slightly better than market leverage. Using the updated or R&D adjusted Z. The Merton DD and the CHS model seem to clearly outperform the other measures. While this is only one analysis. for the remainder of the paper.and O-score don't perform very differently than the unadjusted models. Distress is one of the four default measures used.

and long horizons. which reflects the additional explanatory power the distress measure provides beyond market leverage. In this sense. The industry fixed effect will capture industry specific risk. In this framework. % Improvement.a subsequent period. including market leverage. We regress change in yield spread from prior year on change in distress measure over the same time period in the spirit of Fama-MacBeth. We also compare the results of the different distress measures to relying on market leverage and report. The Z-Score has the lowest R-squared across all the models. CHS Score has the highest adjusted Rsquared followed by Merton-DD. we regress credit spreads on the distress measure alone. we conduct further regression analysis. we then include industry control variables. we find that the Z-Score underperforms market leverage in all three Panels. We regress each distress measure in the cross-section. we take a simple empirical approach. In Panel A. The results of the regression tests are presented in Table 5. The O-Score is marginally better in The Merton DD and CHS Score are dramatically better in explaining credit spreads than market leverage. In Table 6. we follow the approach of Fama and MacBeth (1973) and report the time-series average of the coefficients. To build a time-series. along with t-statistics based on Newey and West (1987) standard errors. In Panel D. The O-Score 17 . we add time-to-maturity to ensure that differences in risk associated with different time-to-maturity is not driving our results. the credit spread. We note that all our distress measures are designed to predict financial failure in one-year horizon. In Panel C. Z-Score or O-Score with the CHS Score having slightly higher explanatory power than the Merton DD Score. As a further test of the explanatory power of these distress scores. The average adjusted R-squared is used to assess the relative power of these measures to explain the market's perception of risk. we examine the ability of distress measures to explain credit spreads after any time constant explanatory variables are removed. In Panel B. We include the distress measures and time-to-maturity as the explanatory models. We believe that these measures should also capture a significant part of distress risk in any short. our work also sheds light on out-of-sample predictability of financial failure of different distress measures. we explore the sensitivity of yield spread to the change in distress risk. explaining credit spreads than market leverage. To assess performance. We begin by including firm and industry fixed effects in Panel A. Overall.

Despite the strong economic intuition suggesting that industry effects should be an important component in bankruptcy prediction.and O-Score is due to their relatively slowness in updating predictive constituents: these two scores are updated annually but Merton-DD and CHS Score are updated monthly. Different industries also face different levels of competition. we focus on 6 industries only. controlling for time-to-maturity. Though not tabulated. but firms in different industries have different accounting rules. Next. we would hope to see a high and similar R-Squared across industry. we separate sample firms by industry and examine the relative performance of each measure in each industry. Second. To assess if this is the case. implying that the probability of bankruptcy can differ for firms in different industries with otherwise identical financial statements. We regress spread on each distress measure. which group sample firms into four industry categories and find that predictive variables have different power to forecast bankruptcy for different groupings. Z-score and O-Score. While the explanatory power improves. we report coefficient and t-statistic on each distress measure in upper panel and adjusted R-squared in bottom panel. 18 .outperforms the market leverage model by 18%.4 Relative Performance across Industries A researcher may be concerned that distress measures could have significant variation across industries. the ranking of the different distress scores remains the same with the Z-Score having the lowest and the CHS score the highest. The only exception is Chava and Jarrow (2004). 5 3. As before. For a distress measure to be accurate. We find appreciably higher explanatory 5 This is essentially an annual analysis since we only have one observation for each firm-year in the sample. This analysis thus alleviates a potential concern that the poor performance of Z. distress measures use financial information in their construction. industries respond differently to macro economic shocks. not much attention has been paid to industry effects in extant literature. we add year fixed effects to capture macro level risk changes in Panel B. in Table 7 Panel A. Firms may be more or less sensitive to the risk factors included in distress measures. We find significant variation and low power for market leverage. mostly likely due to the limited number of bankruptcies in each industry. we also only use yield spread in December or yield spread in the fiscal ending month for each firm-year to conduct Fama-MacBeth regression analysis and obtain similar results. but the Merton DD and CHS model have notably higher explanatory power. First. Given that we do not have sufficient number of firms in agriculture industry (1digit SIC code = 0) and in other service (1-digit SIC code = 8) and public admin and other (1digit SIC code = 9) industries.

the CHS Score outperforms the Merton-DD.5 Relative Performance over Time There is a broad variation in corporate failures over time. we conduct our regression analysis in three different time periods and in normal and shock economic periods. 1994. market-to-book ratio. 2000. O-Score (36%). In Table 7 Panel C. Market-to-Book. For this reason. and 2001. market-to-book ratio.power for the Merton DD and CHS Score as compared to the other 3 measures. distress risk is highly associated with equity size.and O-Scores with respect to their effects on yield spreads. 1997. A good bankruptcy forecasting models must quantify the time-series effects of the change in economic structure on financial distress. 1989.6 Relative Performance over Size. including the long-lasting increase in the 1980s and cyclical spikes in the early 1990s and early 2000s. This is universal across all industry types. As we know. and volatility. The CHS Score can explain 54% of cross-sectional variation of yield spread in shock periods. Overall. where shock period includes the year 1987. CHS Score is still the best measure of financial distress in all 6 industries. 3. we sort firms by market equity. 3. we control for time to maturity and industry effect but only report coefficients on distress measures. market-to-book. This number is much greater than the corresponding numbers for Merton-DD (45%). and volatility quartiles So far we have shown that in both short and long horizons. We also conduct regression analysis on all firms in the two middle quartiles and report the results under “middle quartiles”. and volatility to examine further the relative performance of each distress measure. We also find much less variation in the explanatory power across industries for these two measures. The CHS Score outperformance is more evident during years of economic shocks. which outperforms Z. As before. in Table 7 Panel B. We report Newey and West (1987) adjusted t-statistics and time-series average of adjusted R-squared for 19 . and market leverage (37%). and equity volatility respectively into four quartiles and conduct regression analysis in each of the two extreme quartiles and report results under “lower” and “upper” quartiles. Next we separate sample firms by size. Z-Score (27%). It shows that CHS Score outperforms other measures in each time period and in both normal and shock period. and normal period includes the remaining years.

Conclusion The identification of an accurate measure of distress risk is of significant concern for financial research. KMV-Merton distance to default (Merton-DD). Because the LBFI does not provide data on bid-ask spreads. Second. we sort sample firms into quartiles by market-to-book ratio and equity volatility. though CHS outperformance is relatively more evident among firms with high offering amount and coupon rate. We obtain similar results. Similarly. namely. which are not tabulated. 4. we proxy for crosssectional difference in corporate bond liquidity using time to maturity. We use time to maturity to control for liquidity risk in our main analysis. and Campbell et 20 . and log of offering amount. A number of models are currently being used in the literature with outcomes that can be dependent on the measure utilized. Altman (1968)’s ZScore. we sort firms into quartiles by bond age.7 Liquidity and Tax Effects The literature suggests that liquidity and tax factors explain a significant part of yield spreads. 3. it only outperforms other measures among firms with largest volatility. We also proxy for tax effect on the cross-sectional variation in bond spreads using bond coupon. Overall. We conduct two additional tests to examine the robustness of our results to liquidity and tax effects. We conclude that CHS’ outperforms other measures among firms with highest distress risk. First. The Adjusted R-squared is around 25%-37% and decreases in size for Merton-DD and CHS Score and is around 22% for market leverage. offering amount and coupon rate respectively and conduct regression analysis in each quartile (results not reported). CHS outperforms other measures in smallest size quartiles but does not outperform other measures in larger size quartiles. we include log of offering amount (log of bond age) and coupon as regressors in the multivariate regression. O-Score. log of bond age. the effect of distress risk on yield spread is in general more prominent in small firms.each specification. we compare the relative performance of the four most commonly used distress measures. and Z-Score. Our conclusion remains intact for each quartile. In this paper. In terms of relative performance. While CHS Score outperforms other three measures in each M/B quartile. Ohlson (1980)’s O-Score.

We find that CHS Score has the greatest explanatory power over cross-sectional variation of cost of debt followed closely by Merton-DD. in fact. We utilize credit spreads to measure distress risk and compare the default models and our naive measure. the Z-Score and O-Score. across industries. to see which one is the most accurate measure of distress most often performs worse than what we consider the naive model. which should mitigate a concern that we are not capturing some non-linearity in the regression analysis. The two accounting-based measures. market leverage. perform poorly comparing to other two measures. over time. market leverage. We also find that adjusting predictive variables to control for R&D effect and using updated coefficients do not improve the relative performance of these two accounting measures. 21 . The results suggest that relying on either the Z. We find similar results when relying on either a regression or decile approach. while having a significant impact on yield spread and thus containing distress information. and volatility).or O-score for distress risk is highly problematic. We define the best based on the distress measures ability to explain credit spreads in aggregate. (CHS) measure. and relative to market priced risk factors (size. The Z-Score. and that there are easily calculated alternatives with notably greater power in capturing distress risk. market-to-book. Our findings are consistent when relying on bond rating or credit spreads to assess risk.

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705 -8.266 -4.85 2. Z Score R&D Adj. of Observations 394 10.445 -0.044 -3.49 23.231 -1. O Score Updated Z Score Updated O Score KMV DD Control Variables MktCap ($B) Market-to-Book Volatility Maturity Rating 282.49 0.447 1.208 1.798 1.369 15.33 6.51 BBB+/B25th Percentile 118.307 0.285 -1.84 99.556 3.447 -6.99 96.057 5.276 0.660 8.728 1.838 4.26 0.949 BBB Panel B: Industry Classifications SIC Code 0 1 2 3 4 5 7 8 9 Total Industry Classification Agriculture Mining & Construction Light Manufactured Heavy Manufactured Communications & Electric Wholesale & Retail Trade Business Service Other Service Public Admin & Other No.751 0.471 -1.263 3.246 9.890 26.424 0.439 -0.019 1.208 -4.199 -3.608 Percentage (%) 0.799 5.33 8.214 -2.399 -2.333 10.181 0.487 -5.10 32.377 -2.244 -2.Table 1 Summary Statistics Panel A: Descriptive Statistics Mean Yield Spread (bps) Log (Spread) Distress Measures Market Leverage Z Score O Score R&D Adj.746 2.021 0.318 13.406 -5.95 22.60 56.00 100% 24 .66 89.546 -1.432 1.062 -2.303 0.74 0.176 -2.42 100% Cumulative (%) 0.064 5.336 28.56 1.469 -5.188 8.084 -4.58 100.587 28.309 504 120.432 1.098 -4.072 BBStandard Deviation 288.865 0.561 1.17 B75th Percentile 341.562 4.55 78.22 0.564 -5.665 13.241 0.11 11.481 -1.428 23.232 -3.628 5.292 -1.78 23.634 -5.795 BB Median 188.33 9.788 0.729 0.

638 0. As a result. and updated Z Scores and Merton-DD so they are increasing in the probability of bankruptcy.135 0. (2007) to adjust the R&D effects for constituent variables.247 0. yield spreads.089 -0. The signs of the coefficients have been changed to original.280 0.045 -0.037 0.725 0.363 0. Maturity is the number of years until bond maturity.583 0. and the time series average of their cross-sectional distributions is reported in Panel A.565 0.298 -0. 25 .148 0.552 Z-Score 1.099 0.149 0.728 -0.062 0. Z-Score and Up.000 0.611 Note: Our sample firms include all non-financial issuers in LBFI (198001-200612) with necessary CRSP and Compustat information to compute distress measures and controlling variables. CHS Score is the bankruptcy score based on the reduced form model by Campbell et al.696 0.420 0.000 0.583 -0.679 0. (2004). and controlling variables. Firm size is market equity cap.621 1. Z-Score and Adj.634 0. O-Score are constructed by using updated coefficients by Hillegeist et al. Panel C reports Pearson correlations between distress measures. Panel B reports the number of firm-month observations for each of the 8 industries.359 0.677 0.669 0.999 0.097 -0.340 -0.646 0.347 0. DD is distance to default based on Merton (1974) structural model.571 0.384 0. a greater value of all measures signifies higher probability of bankruptcy. (2010).228 -0.602 0.000 0.674 0. For firms with multiple issues only the one with greatest maturity is selected so that each firm will only have one bond in the analysis. Up. O-Score are constructed by following Franzen et al.680 0.247 0. Volatility is the annualized 3-month rolling standard deviation of daily stock returns constructed on by following Campbell et al.416 0.Panel C: Selected Pearson Correlation Yield Spread 0.308 -0. We remove AAA bonds and bonds with less than one-year to maturity.776 Market Leverage 1. Rating is S&P bond rating.234 0.594 -0.062 0.418 0.588 0.656 0. O Score MktCap Market-to-Book Volatility Maturity Rating 1.270 0.587 0.686 1.354 O-Score MertonDD CHS Score Market Leverage Z Score O Score KMV DD CHS Score R&D Adj Z Score R&D Adj O Score Up.991 0. R&D Adj.406 -0.000 0.074 0.287 -0.052 -0.000 0.449 0. All variables are winsorized at 1 and 99 percentiles.571 0.543 0. Market-to-book is the ratio of market equity to book equity.422 0.391 0.582 0.587 0.582 0. adjusted. (2010).236 0. Z Score Up.168 -0. Z-Score is Altman (1968) and O-Score is Ohlson (1980) bankruptcy measures.363 0.

02 -0.86 -2.66 -0.23 -7.33 0.44 -1.50 0.84 -4.55 -0.17 -2.26 0.24 CHS Score BB 0.77 -2.33 -12.68 Merton-DD -6.14 -7.28 -1.68 -6.09 -2.75 -2.33 -3.22 0.92 -2.29 0.41 -2.56 0.03 -1.06 -2.80 -1.95 -3.25 0.58 0.16 -2.56 0.55 -8.35 -3.53 0.43 0.98 -0.79 -5.19 -1.35 0.42 -1.20 -2.53 0.37 -2.44 -2.28 0.52 0.51 -3.Table 2 Bond Ratings and Distress Measures AA All Periods 1980-1982 1983-1985 1986-1988 1989-1991 1992-1994 1995-1997 1998-2000 2001-2003 2004-2006 All Periods 1980-1982 1983-1985 1986-1988 1989-1991 1992-1994 1995-1997 1998-2000 2001-2003 2004-2006 All Periods 1980-1982 1983-1985 1986-1988 1989-1991 1992-1994 1995-1997 1998-2000 2001-2003 2004-2006 All Periods 1980-1982 1983-1985 1986-1988 1989-1991 1992-1994 1995-1997 1998-2000 2001-2003 2004-2006 0.48 O-Score -1.08 BBB Market Leverage 0.78 -2.32 -2.63 -4.50 0.01 -2.31 -11.13 -1.35 -0.37 -4.00 -5.27 -0.49 0.72 -0.16 -2.14 -0.83 -3.41 0.81 -1.31 -6.50 0.81 -8.31 0.31 -4.06 -2.19 -2.97 -3.10 0.63 26 .30 -1.63 -8.56 0.83 -2.05 -6.42 -1.31 -2.91 -1.42 0.41 -2.48 0.50 -2.79 -2.78 -2.09 -3.82 -2.42 -2.52 -0.59 0.90 -2.35 -2.55 -7.54 -1.11 -1.14 -2.42 -4.54 0.28 0.91 -2.28 Z-Score -2.42 -10.13 0.13 -1.07 -9.15 -2.44 0.33 -4.10 -2.48 -6.20 0.18 0.75 -16.87 -1.58 0.10 0.75 -8.80 -1.57 -1.71 -1.26 0.91 -2.47 0.82 -3.59 -9.31 0.32 0.19 -2.26 B 0.87 0.70 -1.66 -2.01 -1.01 -1.15 -1.91 -2.02 -0.08 0.82 -0.06 0.71 -1.80 -9.97 -3.10 -1.06 -2.68 -7.07 -2.29 -2.42 -8.17 0.28 0.72 -1.93 -2.65 0.91 -6.63 -1.18 0.83 -2.45 0.46 -4.29 0.62 -2.30 -4.70 0.15 -3.46 -1.24 -3.39 0.21 -3.36 0.43 A 0.10 0.15 -3.67 -3.26 -2.71 -12.11 -2.20 -8.44 0.62 -6.19 -3.33 -6.52 0.19 0.79 -1.24 0.03 -4.72 -4.74 -1.54 -0.13 -6.

98 -7.64 -7.33 -7.10 -8.28 -8.13 -8.11 -8.67 Note: This table reports the median distress measures during the entire sample period and nine sub-periods by major rating categories.66 -7.25 -6.89 -7.66 -7.14 -8.15 -8.12 -7.30 -8.03 -7.All Periods 1980-1982 1983-1985 1986-1988 1989-1991 1992-1994 1995-1997 1998-2000 2001-2003 2004-2006 -8.29 -7.92 -7.33 -7.62 -7.24 -8.85 -8.87 -7.68 -7.51 -7. 27 .61 -7.11 -8.63 -7.25 -8.91 -7.25 -8.21 -8.03 -8.89 -7.26 -7.14 -7.27 -7.44 -8.86 -8.24 -8.66 -7.25 -7.08 -8.41 -7.91 -7.84 -7.31 -8.96 -7.14 -7.

61 -1.16 -2.38 -12.73 -5.56 0.94 -8.49 Z-Score -4.48 -13.57 0.87 -10.44 0.85 -2.964 B 0.23 -12.78 -8.003 -8.55 -3.19 -4.76 -1.86 -0.30 0.14 -5.80 -2.79 -7.80 -6.25 0.312 -8.99 -1.71 -0.30 O-Score -3.09 -0.89 -3.18 0.50 0.064 -8.45 -2.11 -0.23 -4.47 -8.49 -2.32 0.64 -2.21 -8.62 CHS Score -8.21 BBB BB Market Leverage 0.52 -1.86 -6.87 -2. 28 .522 -8.52 0.09 -14.56 0.525 -7.55 0.68 -2.023 -7.65 -5.444 -7.22 -0.04 -3.74 -3.30 0.10 -1.63 -2.43 0.66 -4.83 0.33 -0.257 -8.005 Note: This table reports the median distress measures in June 2006 by industry and by major rating categories.28 0.67 -2.55 -9.33 0.44 0. We do not report results for “AA” bonds because many industries do not have bonds in this rating category.93 -2.85 -8.294 -8.101 -7.422 -8.18 -3.06 Merton DD -6.24 0.91 -4.96 -2.40 -0.05 -0.70 -7.44 -3.44 -2.Table 3 Credit Ratings.12 -6.766 -7.90 -5.67 -1.38 0.383 -8.25 -1.39 -1.989 -8.57 0.41 0.37 -1. Industry and Distress Measures A Mining & Construction Light Manufactured Heavy Manufactured Communications & Electric Wholesale & Retail Trade Business Service Mining & Construction Light Manufactured Heavy Manufactured Communications & Electric Wholesale & Retail Trade Business Service Mining & Construction Light Manufactured Heavy Manufactured Communications & Electric Wholesale & Retail Trade Business Service Mining & Construction Light Manufactured Heavy Manufactured Communications & Electric Wholesale & Retail Trade Business Service Mining & Construction Light Manufactured Heavy Manufactured Communications & Electric Wholesale & Retail Trade Business Service 0.87 -1.48 -1.26 -5.95 -9.41 -5.212 -7.045 -8.15 -4.26 -1.58 -16.44 -8.94 -9.70 -1.09 -11.47 -2.45 -14.22 0.947 -8.

1% 34.5% 40.8% 45.4% 48.2% 42.9% 57.6% 38.9% 37.7% 50.2% 42.3% 57.0% 37.2% 37.9% 35.3% 11.6% 44.3% 37.1% 42.4% 70.9% 53.7% 46.3% 73.5% 66.6% 48.5% 41.4% 42.8% 44.5% 36. 29 . We then compute the time-series average of the percentage of firms in the distress measure decile that are also in the same or the adjacent deciles based on credit spread sorting.8% 34.6% 38.6% 37.5% 56.9% 59.7% 51.9% 33.5% 43.0% 60.9% 39.9% 51.5% 40.9% 66.0% 45.3% 72.0% 52.0% 35.9% 44. In Panel B.6% 55.1% 53.0% 24. In Panel A.0% 34.5% 42.1% 50.7% 37.6% 27.3% 43.8% 80.1% 42.5% 54.5% 68.0% 42.7% 42.6% 33.4% 50.0% 44.0% 40.2% 40.8% 62.6% 44.1% 43.5% 34.7% 37.4% Note: This table reports results based on single and double sorting.2% 48.6% 45. we sort firms into deciles based on each distress measure and also on credit spreads in June of each year.4% 49.2% 44.4% 28.8% 1 2 3 4 5 6 7 8 9 10 50.9% 69.8% 39.1% 50.7% 43.5% 30.9% 38.8% 47.7% 53.6% 23. we sort firms into 10 deciles by each distress measure in June 2006 and compute the average yield spread for each decile.4% 44.3% 38.0% 45.Table 4 Decile Analysis Market Leverage 126 138 174 178 237 246 245 229 306 429 Z-Score Original 130 174 201 190 236 245 291 259 273 378 Z-Score R&D Adjusted 130 176 200 187 237 245 277 277 270 378 Z-Score Updated O-Score Original O-Score R&D Adjusted O-Score Updated 308 291 233 225 190 161 160 167 229 418 Decile 1 2 3 4 5 6 7 8 9 10 DD 100 132 161 167 206 228 275 285 307 519 CHS 142 144 153 166 196 206 233 260 348 531 Panel A Average yield Spread Across Deciles 131 134 126 175 168 163 171 203 194 215 175 183 181 219 217 233 228 260 249 234 225 234 257 255 327 303 307 464 457 450 Panel B Double Sorting Percentage Analysis 51.

the independent variable is each distress measure. All t-statistics (in parentheses) are adjusted using the Newey-West(1987) procedure with lag 12.971 (39.97 0.323 383 n.53) -0.29) Included 0.71) Included 0.16) 0. the dependent variable is log yield spread.008 (-3.022 (-12. In Panel A. 30 .061 7.10) 0.02) -0. R-Squared Number of Firms % Improvement Panel C Distress Measure (t-stat) Maturity (t-stat) Industry D.005 (-2.029 4.467 383 45% 0.77 0.292 383 -29% 0. we control for time to maturity.144 (21. We conduct cross-sectional regression each month and compute the time-series average of coefficients and adjust R-squared.015 (-11.09) -0. and the independent variable is yearly change in distress measures from t to t+12.514 383 25% 0.81) -0.23) 0.357 (6.82) -0. B. R-Squared Number of Firms % Improvement Panel D Altman Z-Score 0.29) 0.36) -0.a.410 383 0% 0.005 (-2.005 302 -68% Merton DD 0.011 302 -34% Ohlson O-Score 0.83) 0.362 383 n.006 (-3.485 383 34% 0.37) Included 0.435 383 35% 0.011 (-6.135 383 -58% 0.004 (-2. Adj.410 383 n.37) -0.235 (29. Coefficients on intercept and industry dummies are not reported.294 (27.Table 5 Credit Spreads and Distress Measures: Regression Analysis Market Leverage Panel A Distress Measure (t-stat) Adj.196 (29.45) Included 0.03 302 77% CHS Score 0.V.60) 0.957 (37. In Panel D.367 383 1% 0. In Panels A.189 (29.a.004 (-1.23) 0. and C. In Panel C.15) 0.28) 0.34) -0. 0.029 5.308 (33.04 0.55) -0.105 302 517% 2.452 383 25% 0. In Panel B. R-Squared Number of Firms % Improvement Note: This table reports Fama-MacBeth regression analysis results. R-Squared Number of Firms % Improvement Panel B Distress Measure (t-stat) Maturity (t-stat) Adj.731 (38. the dependent variable is change in log yield spread from month t+1 to t+13. 1.342 383 6% 0.88) 0.9 0.14) 0.a.711 (37.a.042 (38.474 383 16% 0. Distress Measures t-stat Adj.244 12.694 (34.15 (23.017 302 n.19) Included 0. 1.294 (31.213 383 -41% 0.017 (-8.154 (23. we control for time to maturity and industry effects. “% improvement” is the percentage change in adjusted R-squared for each model compared to market leverage model.67) -0.

286 (36.306 18% 0. 0.022 (-15. 0. 31 .02 (-13.25) -0.011 (-7.06) 0.312 10.369 10.282 10.36) -0.306 57% Panel B Firm.306 29% Note: This table reports results for regressions with fixed effects using sample firms in June of each year.011 (-9.01) 0.68) 0. year.483 10.82) 0.8) -0.395 10.9) 0.306 -10% 0.249 (22. Coefficients on intercept and industry dummies are not reported.33) -0.26) 0.306 -11% 0. Panel A reports regression of log yield spread with fixed firm and industry effects.131 (40.019 (-13. and Industry Fixed Coef t-stat Maturity t-stat Adjusted R-Squared Number of Firms % Improvement 1.36) -0.28) 0.306 43% 0.2) -0.445 10.57) 0. and industry effects.6) -0.014 (-10.12) -0.008 (-6. Year.94) -0.575 10.a.524 10.134 (38.246 (23.306 n.811 (31.306 n.Table 6 Regression with Fixed Firm and Year effects Market Leverage Altman Z Score Ohlson O Score Merton DD CHS Score Panel A Firm and Industry Fixed effect Distress Measures t-stat Maturity t-stat Adjusted R-Squared Number of Firms % Improvement 1.679 (52.008 (-5.53) 0.009 (-6.306 18% 0.007 (-5. Panel B reports regression of log yield spread with fixed firm.446 10.49 10.25) -0.288 (37.a.709 (29.306 9% 0.58) 0.683 (52.

589 -10.77 0.267 5.71 0.237 -38% 0.267 -26% 0.449 24% 0.435 84% 0.362 0.12 0.Table 7 Regressions by Industry. R-Squared % Improvement 32 .95 0.06 0.448 18% Communication and Electronics 1.445 91% Whole and Retail Trade 2.65 0.399 71% 0.187 -6.002 20.176 -10.16 0.233 0.23 0.564 42.58 0.952 15.704 30.253 -37% 0.96 0.03 0.27 0. and Volatility Panel A.03 0.236 24.40 0. Subperiods.187 -21% 0.312 34.33 0.66 0.94 0.438 85% Market Leverage t-stat Adj.318 -12% 0. Market-to-Book Ratio. R-Squared Z Score t-stat Adj.629 15.381 0. R2 % Improvement CHS Score t-stat Adj.516 29% Business Service 1.827 35.62 0.237 0.06 0.401 0.62 0.233 -49% 0. R-Squared % Improvement Merton DD t-stat Adj. By Industry Mining and Construction 1.256 11.357 -7.3 0.409 7% 0.29 0.139 12.68 22.461 0.219 9.297 16.438 21% Light Manufactured 2.164 22.143 20.86 0.53 0.191 -18.31 33% 0.197 -17% 0.197 -15% 0. Market Cap.384 -4% 0.441 -4% 0.034 33.28 0.35 0.195 16.736 22.446 14.489 22% 0.267 22.185 17.478 4% Heavy Manufactured 2. R-Squared % Improvement O Score t-stat Adj.329 23.383 -17% 0.81 0.85 0.28 0.141 19.381 0% 0.273 25.8 0.

39) 0.899 (23.81) 0.157 (8.299 -29% 0. R-Squared Z-Score t-stat Adj.135 (16.355 -3% 0.86) 0.421 0.319 (17.448 0.289 (23.22) 0.495 11% 0.46) 0.98) 0.340 -19% 0.08) 0.561 34% 0.12) 0.990 (20. R-Squared % Improvement CHS Score t-stat Adj. Leverage t-stat Adj.708 (32.65) 0.331 -26% 0.301 (29.453 24% 0.36) 0.297 -29% 0.018 (38.557 24% 413 1990-1999 1.423 0% 0.67) 0.248 -32% 0.3) 0.720 (21.539 47% 420 33 .18) 0.366 0.133 (22. R-Squared % Improvement Merton-DD t-stat Adj.04) 0.270 -26% 0.231 (15.584 39% 468 Normal 2.56) 0.08) 0.637 (17.16) 0.508 21% 371 Shock 1.429 -4% 0.241 (30.391 7% 0.645 (18.56) 0.56) 0.19) 0.87) 0.267 (30.440 20% 0.264 (19.89) 0.726 (25.031 (27.141 (22.49) 0.3) 0.422 15% 285 1990-1999 2. R-Squared % Improvement O-Score t-stat Adj. R-Squared % Improvement Number of Firms 1980-1989 1.171 (10.770 (24.Panel B Different Time Periods and Normal/Shock Macroeconomic Periods Mkt.420 0.68) 0.366 0.225 (20.479 14% 0.248 (17.210 (13.

35) 0.41) 0.72) 0. 1994 (high interest rates).31) 0.237 -8% 0. R-Squared % Improvement Merton-DD t-stat Adj.238 (18. R-Squared % Improvement Number of Firms Note: In Panel A. R-Squared % Improvement CHS Score t-stat Adj. and industry dummies are 34 .17) 0.049 (10.325 0.03) 0.099 (17.227 1% 0. and conduct regression in each period.191 -15% 0.383 (16.330 -2% 0.550 11% 96 Bottom Quartile 1.32) 0.33) 0. Also reported are the average adjusted R-squared and the number of firms in the cross-sectional regression.691 (15.321 27% 0.101 (9. we first sort firms into four quartiles every month from 198001-200612 by market equity cap.245 (22.160 (22.43) 0.361 11% 0.43) 0.189 (19.211 -29% 0.517 4% 0.583 (19.416 -16% 0. we separate sample firms into three time periods (1980-1990. Coefficients and t-statistics for intercept.31) 0.24) 0.258 0.159 (26.252 -15% 96 Volatility Middle Quartiles 1.23) 0. Leverage t-stat Adj. R-Squared Z-Score t-stat Adj.488 26% 0. 1997 (Asian financial crisis).84) 0. R-Squared % Improvement O-Score t-stat Adj.471 49% 0.239 -25% 0.298 -11% 191 Upper Quartile 1.226 (13. In Panel B. 1989 (real estate bubble).49) 0.546 10% 0. and equity volatility respectively and then conduct regression within each quartile of Q1 and Q4 and two quartiles of Q2 and Q3 together.070 (13.92) 0. where shocks years include 1987 (stock market crash).12) 0.661 (30.01) 0.247 (18.662 (32.666 (27.283 -27% 0.443 (17.61) 0.9) 0.71) 0.4) 0.Panel C.265 -11% 0.113 (19.296 0.209 -38% 0.247 -2% 0.558 (22.320 1% 0.43) 0.241 -19% 0.085 (6.253 0.47) 0.467 48% 96 Mkt.275 6% 0. Market-to-Book.09) 0.606 (19.25) 0.318 (28.15) 0.257 0% 96 Bottom Quartile 1. and 2001 (9/11 incident). 2001-2006) and into normal and shock macroeconomic periods. In all Panels we control for maturity. We run cross sectional regression on distress measures and report the timeseries average of coefficients and associated t-statistics (in the below parentheses) adjusted by Newey-West (1987) with lag 12. 2000 (Internet bubble). By Quartiles of Firm Size.165 (18.557 (31.86) 0. and normal years include all remaining years. 1991-2000.31) 0. In Panels B and C we also control for industry effect.318 26% 191 Upper Quartile 0.203 -38% 0.81) 0.177 (7.316 0. and Volatility Bottom Quartile 1. In Panel C.167 (13.78) 0.571 47% 95 Market-to-Book Middle Quartiles 1.686 (28.291 (21.118 (19.446 98% 95 Market Cap Middle Quartiles 1.231 -11% 0.29) 0.169 (12.128 (9.225 0.366 62% 0.66) 0.336 0.192 (27.9) 0.164 (14.6) 0.166 (11.409 5% 0. maturity. market-tobook ratio.65) 0.653 (33.75) 0.94) 0.274 (19.703 (23.66) 0.204 -19% 0.190 (9.56) 0.496 0.315 -6% 0.263 (24.27) 0.174 (28.305 (28.388 0. we separate sample firms into 6 industries and conduct regression analysis within each industry.7) 0.1) 0.879 (11.326 (22.370 14% 191 Upper Quartile 2.608 (23.357 10% 0.75) 0.24) 0.