Distressed Debt Returns: 31 Years of Data From Default to Emergence
Corporate Financial Distress, Restructuring, and Bankruptcy by Edward I. Altman, Edith Hotchkiss, and Wei Wang (Wiley, ISBN 978-1-119-48180-5)
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The second half of Chapter 15 is where Altman puts real numbers on distressed debt investing. Using the Altman-Kuehne indexes he’s tracked since 1987, the picture that emerges is more complicated than the “buy cheap debt, make a fortune” story.
The Altman-Kuehne indexes
These indexes track monthly returns on defaulted bonds (since 1987) and defaulted bank loans (since 1996) from default through emergence or liquidation. Distressed debt fund managers use them as performance benchmarks.
As of December 2017, the defaulted bond index held just 55 issues, down from 101 at year-end 2016 and a fraction of the 231-issue peak in 1992. The index caps any single issuer at 10% of total market value and only includes issues with consistent monthly quotes.
31 years of bond returns: the headline numbers
From 1987-2017, the arithmetic average annual return on defaulted bonds was 10.90%. That sounds competitive with the S&P 500 (11.94%) and high-yield bonds (9.25%).
But the compounded annual return tells a different story: just 5.82% for defaulted bonds versus 10.52% for stocks and 8.32% for high-yield bonds.
Why the gap? Defaulted bonds posted negative returns in 13 of 31 years. Stocks had only 5 negative years. High-yield had 6.
The volatility is brutal. Annual standard deviation: 34.16% for defaulted bonds vs. 17.00% for stocks and 14.66% for high-yield. The return-to-risk ratio favored high-yield (0.63) and stocks (0.70) over defaulted bonds (0.32).
The boom years make the asset class
Without a few spectacular years, the whole story changes:
- 1991: +43.11%
- 2003: +84.87%
- 2009: +96.42%
- 2016: +75.39%
And the crash years hurt just as hard:
- 2008: -55.09%
- 2015: -39.54%
- 2000: -33.09%
Defaulted bonds trade flat (no coupon payments), which adds to volatility. But the low correlation with other asset classes during stressed cycles partially offsets this.
Defaulted loans: worse than bonds
From 1996-2017, defaulted bank loans returned just 4.93% arithmetic average and 3.44% compounded. Despite being senior secured, defaulted loans underperformed both stocks and high-yield bonds.
The combined bond-and-loan index did somewhat better (6.78% arithmetic, 3.95% compounded) but still trailed mainstream assets.
Distressed (not yet defaulted) bonds
Using the BofA Merrill Lynch Distressed Index (bonds yielding 1,000+ bps over Treasuries), the 2008-2017 arithmetic average was 12.94%. But geometric mean was only 4.70% due to -20.18% in 2014 and -37.99% in 2015.
Sharpe ratios over 10 years: S&P 500 (0.42), high-yield (0.35), distressed bonds (0.09), defaulted bonds (0.03).
Post-default experience: where the money is made
This is the most actionable data in the chapter. Altman analyzed 1,189 bond issues from 803 firms (1987-2016) and 730 loan facilities from 398 firms (1996-2016).
Average time in bankruptcy: 28 months for bonds overall, but only 16 months for 2006-2016 (thanks to BAPCPA’s 18-month exclusivity limit and more prepackaged filings).
Returns from default to emergence:
- All bonds, 1987-2016: 11.08% annualized
- All bonds, 2006-2016: 25.34% annualized
- 12 months post-default: 8.49% (full sample), 26.20% (recent 10 years)
- 24 months post-default: 13.58% (full sample), 19.92% (recent 10 years)
The recent period dramatically outperformed the full sample. Bankruptcy code reforms and faster restructurings helped.
Seniority breakdown: the critical detail
This is where the literature review findings become concrete:
| Seniority | Default to Emergence Return |
|---|---|
| Senior unsecured | 17.4% annualized |
| Senior secured | High single digits |
| Subordinated | -2.4% annualized |
| Subordinated (months 1-12) | -10.9% |
Senior unsecured bonds were the sweet spot. Subordinated bonds lost money. If you remember one thing from this chapter, it’s this table.
Prices still fall before default
Even with more sophisticated markets, bond prices decline steadily before default:
- 6 months prior: -38.52%
- 1 month prior: -16.81%
The distressed debt market hasn’t become so efficient that you can’t still lose money buying too early.
The chapter’s honest conclusion
Looking at long-term index returns, distressed investing doesn’t look great compared to stocks or high-yield bonds. Except for senior unsecured tranches.
But hedge fund managers don’t buy index portfolios. They pick securities, hedge positions, switch between debt and equity, and time credit cycles. The low correlation with other assets, the ability to exploit boom years, and the optionality of control strategies keep institutional interest alive.
And with corporate debt at record levels after a long benign credit cycle, the authors expect dramatically heightened interest when the next crisis hits.
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