The Anatomy of Distressed Debt Markets
The market for investing in distressed debt securities, the so-called ‘vulture’ markets, has captured the interest of increasing numbers of investors and analysts. These investors, sometimes categorized as ‘alternative asset’ institutions, mainly hedge funds, now can convincingly argue that the market has matured into a genuine asset class, with a reasonably long history of data on return and risk attributes.
In earlier works, Professor Altman has helped to classify this market into two distinct categories: (1) bonds or loans whose yield to maturity (later amended to option-adjusted yield) was equal to or greater than 10% (1,000 bps) above the 10-year US government bond rate (later amended to be the US government bonds with comparable duration) and (2) those bonds or loans of firms who have defaulted on their debt obligations and were in restructuring, usually under Chapter 11. The former was categorized ‘Distressed’ and the latter as ‘Defaulted’.
The attraction of this asset class is not only in its stand-alone individual security performance but also, very importantly, in its extremely low return correlation with other asset classes, where typically during stressed credit cycles (and the subsequent recovery), correlations between the stock market and risky debt markets are quite low.
In a recent article, the authors document the descriptive anatomy of the distressed debt market’s size, growth, major strategies, characteristics, and participants, and then explore its performance attributes, reviewing the relevant 30-year period from 1987–2017.
The performance of a large sample of defaulted securities during the post-default period is analyzed, covering the period 1987 to 2Q 2016 for defaulted bond prices and the period 1996 to 2Q 2016 for defaulted loans. The monthly performances from default to emergence and the 1–24 months after default are analyzed, as well as the performance from before and after the major changes to the US Bankruptcy Code in late 2005. Finally, the six-month period prior to default experience is also analyzed.
It is observed that the annualized average rate of return for all bonds from default to emergence (1987–2016) was 11.08% per year. This is decent, but much lower than the 25.34% per year for the more recent 10-year period (2006–2016). If an investor purchased our entire sample of defaulted bonds at default and held them for 12 or 24 months, the average annualized returns were, respectively, 8.49% and 13.58% on just those bonds that lasted for those intervals. For the most recent 10-year sample period, the annualized returns were much greater; 26.20% for 12 months and 19.92% for 24 months.
An analysis of the return history shows that the seniority of the bond issue is an extremely important characteristic of the performance of defaulted securities over specific periods. On the other hand, bank loans in default, which are primarily senior-secured, do not do well during reorganization, as our analysis in the article shows, although their returns are far less volatile.
Despite reasonably good average return performance for defaulted bonds, especially in the last 10-year period, there are some stark differences between bonds with different seniorities. Senior unsecured bonds demonstrated excellent average annual returns for all the periods considered, ranging from 17.4% for default to emergence, to 28.5% for the 12–24 month period, while the senior secured sample showed only modest high-single-digit returns. The results for the subordinated class were very disappointing, with the average annual return from default to emergence actually negative, at -2.4%, and even lower, at -10.9%, during months 1–12.
The defaulted loan performance statistics for all periods indicate much poorer performance than for defaulted bonds. Indeed, all average annual returns were in the low to medium single digits for the interval default to emergence. Specifically, the annualized average rate of return for all loans (1996–2016) was 2.76% per year. This compares with 4.45% per year for the more recent 10-year period (2006–2016).
Finally, the price behavior of defaulted bonds is examined for a period of 6 months to 1 month before the default date. During a holding period from 1 month to 6 months prior to default, using a large sample of bonds with available prices, the percent change in the average price shows a steady monotonic decline across all periods from -38.52% six months prior to default to -16.81% one month prior to default. So, despite the fact that distressed debt markets have become increasingly competitive and analyzed by numerous investors, defaulted bond prices still fall significantly from six months prior to default and even from just one month prior.
The article notes a number of unique aspects which make this asset class attractive, especially to hedge fund managers who can move in and out of the securities depending upon the credit cycle. Additionally, big-bet hedge funds will usually find assets that combine hedging possibilities with the opportunity to exploit periods of spectacular returns incredibly appealing. Not all asset managers have exploited those challenges in the past, however, nor do they have the staying power to survive large negative periods. Distressed debt as an asset class has matured greatly in the 30 years or so that we have been following its development. Still, its popularity and general interest ebbs and flows over the credit cycle.
Edward I. Altman is Professor Emeritus, NYU Stern School of Business and Director of Fixed Income & Credit Research, NYU Salomon Center.
Robert Benhenni is Professor, Léonard de Vinci Pôle Universitaire, Paris and Visiting Scholar, NYU Stern School of Business.
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