Credit Risk and Anomalies in Pakistan’s Stock Market

• Author: Jungwon Suh,Abdul Qayyum
• DOI: http://doi.org/10.1111/ajfs.12280
• Date: 01 December 2019
• Published date: 01 December 2019

Credit Risk and Anomalies in Pakistan’s

Stock Market*

Abdul Qayyum

Department of Business Studies, Bahria University Islamabad, Pakistan and Business School, Sungkyunkwan

University (SKKU), Republic of Korea

Jungwon Suh**

Business School, Sungkyunkwan University (SKKU), Republic of Korea

Received 10 May 2019; Accepted 18 September 2019

Abstract

This paper investigates the relation between credit risk and stock return for publicly traded

firms in the Pakistan Stock Exchange (PSX) over the period 2000–2017. Using credit ratings

as a proxy for credit risk, we find that the credit risk–stock return relation is negative in Pak-

istan, as low-rated stocks (i.e., those with high credit risk) earn lower returns than high-rated

stocks (i.e., those with low credit risk). This negative relation is robust to alternative mea-

sures of credit risk (e.g., Altman’s Z-score and the distance-to-default) and is also maintained

even after controlling for size, momentum, and liquidity effects. Our study provides evidence

of the default-risk anomaly in a frontier market that lacks adequate information infrastruc-

ture and faces high levels of political and economic uncertainty.

Keywords Default-risk anomaly; Credit risk; Stock returns; Size effect; Credit ratings; Alt-

man’s Z-score

JEL Classification: G11, G12, G24, G32

1. Introduction

Understanding the cross-section of stock returns is central to research in financial

economics. Over the past several decades, researchers have documented evidence

that the fundamental risk–return relation has limited power to explain the cross-

sectional variation of stock returns. They have found several anomalies, such as size

and book-to-market effects, that influence stock performance but do not appear to

reflect systematic risk factors (Fama and French, 1992, 1993). A related anomaly is

the credit risk–return puzzle (also known as the default-risk anomaly or the

*This work was supported by the Ministry of Education of the Republic of Korea and the

National Research Foundation of Korea (NRF-2017S1A5A2A03067521).

**Corresponding author: SKKU Business School, Sungkyunkwan University, Seoul 03063,

Republic of Korea. Tel.: +82-2-760-0482, fax: +82-2-760-0440, email: jungwonsuh@skku.edu

Asia-Pacific Journal of Financial Studies (2019) 48, 808–843 doi:10.1111/ajfs.12280

808 ©2019 Korean Securities Association

financial distress anomaly), where realized stock returns are lower for high credit-

risk stocks than they are for low credit-risk stocks. This puzzling pattern violates

the standard risk–return relation as stocks with high risk (i.e., high credit risk) yield

lower returns than other stocks. Researchers have employed a variety of methods to

measure credit risk, including credit ratings, the Z-score, the O-score, logit regres-

sion, and the distance-to-default model. Their studies largely confirm the presence

of the default-risk anomaly in the United States.

The present study examines whether the default-risk anomaly exists in publicly

listed Pakistani firms. It is worthwhile analyze whether a well-known empirical reg-

ularity or anomaly also holds in countries outside the United States such as Pak -

istan, a frontier market.

1

On the one hand, frontier markets typically have

inadequate information infrastructures and lack investor sophistication so default

risk may not be properly (or sufficiently) discounted in stock prices, in which case

the default-risk anomaly may hold in those markets. On the other hand, frontier

markets experience extreme volatilities because of political and macroeconomic

uncertainties endemic to those markets and such volatilities could suppres s empiri-

cal regularities, including the default-risk anomaly.

2

We use the Bloomberg database to construct our sample of Pakistani stocks for

the period 2000–2017. We employ two measures of credit risk: credit ratings and Alt-

man’s Z-scores. Accordingly, we create two samples, the credit-ratings sample and the

Z-score sample. Our results find a negative relation between stock returns and credit

risk. When we create five subgroups of stock-months based on credit ratings or Z-

scores, stock performance declines monotonically from the lowest credit-risk stocks to

the highest credit-risk stocks. Also, the premium between the two extreme credit-risk

quintile portfolios is significantly positive. We use several alternative measures of

stock return performance, including excess return and alphas from the capital asset

pricing model (CAPM), Fama and French’s (1993) 3-factor model, Carhart’s (1997)

4-factor model, and Fama and French’s (2015) 5-factor model. Our key finding

remains unaltered, suggesting that the default-risk anomaly exists in Pakistan.

In search of the cause or driver of this anomaly, we examine whether the nega-

tive credit risk–return relation arises from or is linked to some other anomalies in

Pakistan’s stock market, such as size, book-to-market, profitability, investment, and

1

Although the dividing line between frontier and emerging markets is blurred, frontier mar-

kets are regarded as smaller and less-developed than emerging markets, but still investible

(see, e.g., Constable, 2015). MSCI Inc. classified Pakistan as an emerging market over the per-

iod 1994–2008 so Pakistan was part of the MSCI Emerging Markets Index during that period.

However, the company removed Pakistan from that index in 2008 and afterward assigned it

to the Frontier Markets Index in 2009. This classification had been maintained until the

country was upgraded to an emerging stock market in June 2017.

2

While Pakistan ranks 132

nd

in the world in terms of purchasing power parity (PPP) GDP

per capita, its economy ranks 24

th

in the world in terms of GDP (https://en.wikipedia.org/

wiki/Economy_of_Pakistan).

Credit Risk and Stock Return in Pakistan

©2019 Korean Securities Association 809

momentum effects. Among those five effects, size and momentum are present in

Pakistan, as they are significantly associated with excess returns. Surprisingly, the

results indicate the presence of a reverse size effect, as large firms in Pakistan yield

higher returns than small firms—contrary to the usual size effect in which the

returns of small firms tend to be larger than those of large firms.

This reverse size effect may drive the negative credit risk–return relation, because

large stocks generally have low credit risk compared to small stocks. However, our

results show that the negative credit risk–return relation persists in all size-based sub-

groups, suggesting that the default-risk anomaly is distinct, and not an outcome or a

by-product of the reverse size effect. We also evaluate whether momentum, illiqu id-

ity, or institutional ownership can explain the default-risk anomaly, but none of

these factors is able to subsume the credit-risk effect on stock returns.

In summary, our investigation reveals that a negative credit risk–return relation

is present in Pakistan’s stock market and that this relation is distinct from other

anomalies. Also, unlike Avramov et al.’s (2009) US finding, the negative credit risk–

return relation in Pakistan holds for a relatively broad cross-section of stocks so it

is not necessarily driven by a small fraction of firms that face impe nding bank-

ruptcy or delisting. This study adds to the growing evidence that the default-risk

anomaly is not specific to the United States. Agarwal and Taffler (2008) and Kim

and Shin (2014) report negative credit risk–return relations in the United Kingdom

and South Korea, respectively, using the Z-score and credit ratings as proxies for

credit risk.

Two recent studies, Gao et al. (2018) and Eisdorfer et al. (2018), provide evi-

dence of a default-risk anomaly in multi-country samples using the distance-to-de-

fault measure as a proxy for credit risk. Both studies conclude that the default-risk

anomaly is weak in developing countries, although it is significant in developed

countries. To reconcile our finding with these studies, we use the distance-to-default

measure as an additional proxy for credit risk but find that the negative credit risk–

return relation persists in Pakistan. Although multi-country studies like Gao et al.

(2018) and Eisdorfer et al. (2018) have their own merits, our study of a single

country allows for a more detailed inquiry of the anomaly, for example, concerning

its potential link (or lack thereof) to other anomalies. Indeed, our evidence suggests

that the default-risk anomaly in Pakistan is distinct from other anomalies such as

the size and momentum effects.

Our results are consistent with the misvaluation story (Dichev, 1998; Griffin

and Lemmon, 2002), which suggests that investors fail to discount the prices of

high credit-risk stocks sufficiently to offset their probability of failure. Our observed

negative credit risk–return relation in Pakistan is an anomaly, as this relation does

not appear to arise from risk factors. The negative credit risk–return relation per-

sists after controlling for several effects—such as firm size and momentum effects—

that may be related to fundamental risk. Furthermore, stock returns on credit-risk

sorted portfolios do not vary systematically with the market beta or facto r loadings

on the Fama-French and Carhart factors.

A. Qayyum and J. Suh

810 ©2019 Korean Securities Association