Question 9 Schweser practice exam book 2. Schweser is saying that if the companies situation improves, distressed debt will outperform distressed equity. Does this sound right?
Depends on how much it improves. The distressed debt certainly should improve first.
isn’t this because you shorted the equity in the beginning and bought the debt?
ya, historically distressed debt gains more if things improve vs. equity. and historically is loses less than equity if things go the other way…so it sounds right. debt typically holds its value if things go to hell cuz the holders then takeover the company. debt improves more if things get better cuz the likelihood of debtholders getting their money back improves dramatically.
It’s true if you buy debt and short equity. The debt has first claims to cash therefore it will improve at a higher percentage than the equity, at least in theory. If the business prospects continue to diminish, the theory is you do well on the short equity but not as bad on the debt since tthe debt again has first claims to cash.
prockets Wrote: ------------------------------------------------------- > isn’t this because you shorted the equity in the > beginning and bought the debt? Is that not because debt has higher priority than equity? (so that debt will “recover” first). The thing that you mention seems to be the Distressed debt arbitrage, which is just one of the strategies with distressed securities. - sticky
Equity has no priority - only a residual interest after everyone else has been paid. In a bankruptcy, the old equity almost always gets wiped out. That means there is a very high probability in bankruptcy that your equity will be worth 0 and distressed equity is priced accordingly. Distressed debt has recovery value because it has some kind of claim on assets. It’s possible to find secured debt in bankrupt companies selling at some reasonable fraction of par because the asset securing the debt is valuable enough to cover the debt and it’s just a matter of time. As the situation improves in a distressed company, the bonds improve first because the likelihood of gaining coupon interest increases. This might really matter if the bonds have been selling at 30 with a 10% coupon. Just one additional coupon payment changes your P/L a lot. On the other hand, delaying bankruptcy by 6 months does nothing for equity holders.