Lecture 6 Investing in distressed securities

Question 1

What two main types of distressed securities are there, name example

Answer 1

Debt securities (private and public)
o Loans
o Bonds
o Credit default swaps
Equity
o stocks
o options

Question 2

What are the three main ways of investing in distressed securities?

Answer 2

Active control
Active non-control
passive

Question 3

What are characteristics of active control investors?

Answer 3

o 1/3 minimum to block decision
o Debt equity swap
o Equity infusion
o Restructure firm
o Exit two or three years later
o Target return: 20%-25%

Question 4

what are characteristics of active non-control investors?

Answer 4

o Senior secured, senior unsecured debt position
o No controlling stake
o Active participation in restructuring process
o Exit via debt or equity
o Exit one or two years later
o Target return: 15% to 20%

Question 5

What are characteristics of passive investors?

Answer 5

o Invest in undervalued securities rading at distressed levels
o Strategies: buy-and-hold, capital structure arbitrage
o Exit six months to one year later
o Target return 12% to 20%

Question 6

Exercise for capital structure arbitrage:
- Two zero-coupon bonds with maturity of one year of the same firm
o Senior unsecured bond with recovery rate of 40%
o Subordinated bond with recovery rate of 20%
- Default probability of the firm is 10% discount rate is 10% for both bonds, notional of both bonds is 100
- Assume that you believe that a default of the firm is more likely than 10%
- Set a trading strategy that requires a minimal investment today and deliver return in case of the firm defaulting

Answer 6

First calculate he prices of the two bonds:
Bond 1: expected payout in default = 40% payout in non default = 100 default probability = 10
P = (1000.40.1+1000.9)/1.1=85.45 so expected total value and discount it back
P unsecured = (1000.20.1+1000.9)/1.1=83.64
You believe that the chance of default is higher therefore the senior bond should be worth more compared to the unsecured bond: calculation example you believe the chance is 20%
(1000.40.2+1000.8)/1.1=80
(1000.20.2+1000.8)/1.1=76.36
Short the senior bond long the subordinate bonds:
Today payoff = short of the bond = +83.62, longing the stock = -85.45 = -1.81 cash inflow now
if the bond does not default, you owe the stock which will be worth 100 (since no default) and you have the stock which is worth 100, since no default. So you lost 1.81
If default: you get 40 for the secured bond (recovery rate) and you owe 20 (the recovery rate of the bond you shorted) therefor you make +20 – 1.81 = 18.19

Question 7

What is a synthetic put?

Answer 7

You create a put like payoff structure with yoru strategy, you benefit from downturn

Question 8

The strategy explained ealier what is it called?

Answer 8

long-short strategy, you exploit differences among securities of the firm (seniority, time to maturity)

Question 9

What is the credit spread puzzle?

Answer 9

Estimation of bond prices in credit risk models like the merton model, using historical default and recovery rates produces credit spreads that are far lower than those observed in markets

Question 10

What are determinants of default probabilites and loss given default?

Answer 10

Bankruptcy laws
financial distress costs (impact next point)
bargaining setup and incentives (number of creditors, outside optinos, costs of financial distress, covenants, credit default swaps)
statistical approahces for default prediciton are:
- credit ratings
altmans z score
moodys KMV/EDF model

Question 11

exercise:
Simple model with real data:
- Interest in bond price of senior unsecured zero bond with a remaining maturity of one year (pays back notional of 100)
- Assume that Rd = 5%
- We need PD (probability of default) and LGD informoatin -> use credit rating as a proxy for default probability + historical realizations for recovery rates from moody’s document
- Use 35% as recovery rate (average 1983-2020) and PD of 0.26 (average default rate for baa rated bonds (1920-2020)
- What is the bond price and what are the distress costs?

Answer 11

Bond price = (1000.9974+0.002635)/1.05=95.077
NPV of distress costs (0.0026*65)/1.05= 0.1610

Question 12

Ω=p/(1+rd)*ω explain all the sings of this formula

Answer 12

p: Probability of distress
* Rd: Discount rate
* ω: LGD
* Ω = NPV of distress costs
𝜙 = recovery rate, = 1-w

Question 13

What are potential explanations for the credit spread puzzle?

Answer 13

time varying discount rates
liquidity

Question 14

What are the two main ways to price financial distress costs? you need to know the probability of default the eloss given default and the risk free rates

Answer 14

1. historical averages
2. implied rates in the credit spread, risk neutral default probabilities

Question 15

What are problems with using historical averages to calculate financial distress costs?

Answer 15

Using historical averages, the credit spread should be way lower than it is.
as defaultable bond = risk free bond - npv of distressed costs
Historically, these distressed costs have been very looking ex post..

Question 16

How does the risk neutral default probabilities work?

Answer 16

wUsing the historical average recovery rate and the bond price we can calculate the expecte probability of default. B = (1-p) * f/1+r + p * recovery rate * f / 1 + r
we know the r = risk free rate we konw the average recovery rate we know the bond price and we know the face value we can solve for p

Question 17

key takeaways

Answer 17

• Historical averages of default frequencies and recovery rates cannot explain market prices of corporate bonds -> credit spread puzzle
• Using risk adjusted discount rates for (financial) distress (via risk-neutral default probabilities) can help to alleviate the problem

Question 18

what is the distress anomaly

Answer 18

Corporate finance theory would suggest that stocks that are at high risk of default should have higher returns to compensate for this risk. in reality this is not the case, they have negative alphas.

Question 19

What are the 2 explanations for the distress anomaly

Answer 19

1. a. Stocks with a high default likelihood show higher likelihood of extremely positive returns (like gambling)
   b. People overvalue tail events in their utility function (Based on prospect theory) so they expect they can win the jackpot

2
a. Default risk (PD) does not account for expected losses conditional on default (LGD)
b. Distress anomaly does not appear fro stocks with high expected losses in case of default
c. So to summarize the downside risk is not asmuch as assumed in other models