Distressed and defaulted security investing as a field has suffered from a combination of poor dissemination of the facts, less-than-stellar public perceptions and the ill sentiment associated with much of the field's terminology.
How profitable can an investment niche be that must deal daily with debtors, creditors, bankruptcy codes, courts, liquidations, reorganizations and a multitude of attorneys and advisers (all of whose fees are paid out of the estate of the troubled company)?
For the five-year period ended Dec. 31, 1995, defaulted securities have compounded returns of 20.2% annually and distressed bonds have compounded returns of 22.7% per year. This compares with equity market returns of 16.6% a year for the same period (Exhibit 1).
Regardless of superior returns, mentioning distressed or defaulted securities as a viable alternative asset class for pension funds typically generates such responses as "too risky," "hard to understand" and "difficult to oversee," among other negative comments.
This article seeks to address five of the myths portfolio managers and plan sponsors might have assimilated over the years.
There is too much
absolute risk involved.
Examination of the distribution of monthly returns from January 1991 to December 1995 shows that although the mean monthly returns of distressed and defaulted securities exceeded that of the Standard & Poor's 500 Stock Index by 42 basis points and 26 basis points, respectively, the absolute risk of the alternative indexes, as measured by the standard deviation of returns, compared very favorably to that of the stock index (Exhibit 2). Also, because the durations of distressed bonds - by virtue of typically high coupons and low prices - are substantially lower than higher-grade issues, price volatility caused by interest rate swings is lessened accordingly.
There is too much
downside risk involved.
While the S&P 500 generated negative returns in 17 of the 60 months through December 1995, defaulted securities returned negative results in only 16 of those months. Distressed bonds, by virtue of the fact that they are still current with their coupons, showed negative returns in just 10 out of 60 months.
In addition, examining two measures of downside risk - semi-variance and 0% target semi-variance - reveals both distressed and defaulted bonds are less prone to downside volatility (Exhibit 3).
One reason for this phenomenon might be that the downside risk of a distressed or defaulted bond, unlike that of most equity of leveraged firms, is usually limited and is a function of the liquidation value of the firm and the standing of the issue in relation to the entire capital structure.
There's no real advantage
to such an allocation.
Because the distressed and defaulted sectors both have low correlation with the S&P 500, any exposure to them should increase total return while lowering total portfolio volatility (Exhibit 4). On a historical basis, a 10% exposure to these markets from 1991 to 1995 would have increased the compound annualized returns of an indexed stock fund by 56 basis points while reducing the standard deviation of monthly returns by 8.6%.
The market's too small
The total market value of the U.S. public and private defaulted and distressed debt was estimated recently at $64 billion, certainly large enough to afford an opportunity for fund diversification.
The liquidity of distressed and defaulted securities is probably closest in nature to the municipal bond market, in that bid-ask spreads are partly a function of issue size, number of holders, sell-side trading/research desk coverage, and post-underwriting support. The last two factors have become especially prevalent in the post-Drexel Burnham Lambert era, as the number of investment banks underwriting and trading high yields paper has increased substantially.
It's too difficult to understand.
The distressed and defaulted investment arena, in the final analysis, is simply one in which cash flow analysis, asset valuation and old-fashioned value investing predominate.
To be sure, there are other forces that come into play; for those distressed/defaulted security managers willing to take a more active role in the reorganization process in search of greater than average returns, it is essential to possess an in-depth knowledge of the Chapter 11 legal framework, as well as negotiating savvy. In addition, active managers in this field benefit not only from experience, but also by having a large amount of assets under management, which allows for more strategic options.
On the whole, however, there is likely less luck involved in pursuing a distressed/defaulted investment strategy than, for instance, charting the direction of interest rates.
That inefficiencies exist in this market are in part a function of the fear and irrationality of investors. For plans that invest in this market, that is good news. The distressed and defaulted security sector, from a risk-return standpoint, is actually quite healthy.
Duane G. Roberts is president and Allan A. Brown is a research analyst at Magten Asset Management Corp., New York.