In the late 1980s, the chairman of The Foothill Group approached Edward I. Altman, already then well known for the creation of the Z-score used for predicting bankruptcy.
The chairman asked Altman to develop a descriptive and analytical white paper on distressed debt. He obliged, writing first a paper on distressed bonds and then one on distressed loans, published in 1990 and 1992, respectively.
One of the contributions of these papers was a formal definition of distress: bonds or loans whose yield to maturity is equal to or greater than 10% above the 10-year US government bond rate. In later work he revised this definition slightly, to the definition that is now canonical—distressed debt consists of those bonds or loans with option adjusted yield equal to or greater than 10% above US government bonds with comparable duration.
In either incarnation, this definition usefully distinguishes debt that is merely distressed from debt that actually has defaulted.
The Foothill Group is now part of Wells Fargo, and a lot of water has passed beneath a lot of bridges since the days that first conversation piqued Altman’s interest.
He is now looking backward, and with the aid of Robert Benhenni, a distinguished Italian finance scholar, Altman has now written what he calls an “anatomy” of the distressed debt markets, mining data from 1987 to 2017. The paper will appear in a forthcoming issue of The Annual Review of Financial Economics.
The Size of the Market
Let us begin with market size. In 1990 Altman estimated that the publicly traded and privately issued market for distressed and defaulted debt was about $300 billion in face value and $200 billion in market value. The highly leveraged restructurings that had taken place in the US corporate world in the 1980s (and were still underway as Altman wrote) made a large contribution to these totals.
The massive defaults of 2000-2002 was the next great impetus for the growth of this space, bringing it to between $700 billion and $1 trillion face value. It stayed in that range until the global financial crisis of 2008-09. That brought the D&D debt space to about $3.6 trillion face value, $2 trillion market value.
The Attraction of this Asset Class
The attraction of this asset class, Altman and Benhenni write, is “not only in its stand-alone individual security performance but also, very importantly, in its extremely low-return correlation with other asset classes.”
The correlation between stock market returns and risky debt market returns is positive, but quite low. In those restructuring years, 1990-91, it was 12%. During the dotcom bust and related scandals involving Enron, WorldCom, etc., in 2001-02, the correlation was just 23%.
Of interest (and attractive to cautious investors): the correlation between distressed and default debt on the one hand and government bonds returns on the other is negative in all periods.
Three Types of Strategy
There are three major types of distressed debt investments: active control; active non-control; passivity. Active control is only for the “big boys.” One must have deep pockets either to take control of a defaulted company through the bankruptcy courts, or to take control of a distressed company as an alternative to default and bankruptcy.
A variant of active control is the “roll-up strategy,” through which bankrupt industry players can be consolidated into one sustainable company This was dramatically accomplished early in this century through W.L. Ross’ roll-up of bankrupt steel companies. Eventually Ross sold the combined firm, ISG, to the Mittal Steel Group.
Active non-control can involve, for example, active participation in the creditors’ committee in a restructuring process, where an investor can work through the process to protect/advance the interests of the class of securities that investor holds.
Finally, of course, there is passive investment, which may be either buy-and-hold or more trading-oriented and may target a return of between 12% and 15%.
The Altman-Benhenni “anatomy” also looks at issues of volatility. “The volatility of the defaulted bond index [whether measured on an annual or a monthly basis] is considerably greater than either high-yield bonds or common stocks when measured on an annual basis, but only slightly greater than common stocks, when measured on a monthly basis.”
As one might have expected, then, measuring at the longer interval has a “calming” effect, lowering the vol of common stock indexes and enhancing the difference between that figure and the corresponding defaulted bond index figure.
Likewise, the coupon payments on distressed but not defaulted bonds no doubt contains the volatility, accounting for the difference between that and the defaulted bonds index.