Market Dynamics and Investment Performance of Distressed and Defaulted Debt Securities

by Edward I Altman of the New York University

December 1998

Introduction: The market for investing in distressed and defaulted debt is continuing to receive a great deal of attention despite the shrinkage in the supply of new securities in the last few years and the recent (1997-98) poor return performance to investors. This is primarily due to the expected growth in the supply of new distressed and defaulted public and private debt paper, the perception that prices are now at attractive levels and the documented relatively low correlation of returns with the more traditional debt and equity markets. This article reviews some of the important attributes of this unique investment vehicle and updates our analysis of the risk and return performance of defaulted debt.

Distressed securities can be defined narrowly as those publicly held and traded debt and equity securities of firms that have defaulted on their debt obligations and/or have filed for protection under Chapter 11 of the U.S. Bankruptcy Code. A more comprehensive definition would include those publicly held debt securities selling at sufficiently discounted prices so as to be yielding, should they not default, a significant premium over comparable duration U.S. Treasury bonds. For this segment, I have chosen a premium of a minimum of 10 percent over comparable U.S. Treasuries. With interest rates falling as much as they have by late-1998, this definition would currently include bonds yielding at least 15.0%.

Finally, distressed securities can include those bank loans and other privately placed debt of the same or similar entities with rather acute operating and/or financial problems. With the continued growth in the volume of distressed bank loans that now trade rather frequently, investors are increasingly aware of the potential price movements of these heretofore illiquid "securities." recent estimates, from professionals, of the annual volume of distressed bank loan trading in the U.S. is in the $10-15 billion range. Indeed, trading is apparently sufficient to have spawned several brokers who specialize in distressed bank debt and most large securities firms have analysts, sales and trading personnel dedicated to this market and investors.

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