While empirical literature has documented a negative relation between default risk and stock returns, theory suggests that default risk should be positively priced. In this paper, we calculate monthly probabilities of default (PDs) for a large sample of European firms and break them down into systematic and idiosyncratic components. The approach that we follow does not require data on credit spreads, thus it can also be applied to small firms that do not have such data available. In accordance with theory, we find that the systematic part, measured as the PD sensitivity to aggregate default risk, is positively related to stock returns. We show that stocks with higher PDs underperform because they have, on average, higher idiosyncratic risk. Finally, small and value stocks are quite heterogeneous with respect to their exposure to aggregate default risk.

In this paper, we examine idiosyncratic and systematic distress predictors for small and medium sized enterprises (SMEs) in Europe over the period 2000–2009. We find that SMEs across European regions are vulnerable to common idiosyncratic factors but systematic factors vary. Moreover, systematic factors move average distress rates and small SMEs are more vulnerable to these factors compared to large SMEs. By including many very small companies in the sample, our models offer unique insights into the European small business sector. By exploring distress in a multi-country setting, the models uncover regional vulnerabilities. Finally, by incorporating systematic dependencies, the models capture distress co-movements.