Schweiser sample exam says that - If a distressed company’s “prospects improve” the debt should appreciate *more* than the equity, due to senior credit position. (relating to short equity, long debt) I am chalking this up to Schweiser’s incompetence… anyone agree with the above statement? My view from experience in distressed deals is that the senior position is solely a structural consideration, and relevant in bankruptcy court proceedings or loan workouts. If prospects improve requiring no dilution to equity, the equity position will completely outperform debt - this is basic risk/return 101. Perhaps CFA is taking a different definition of “distressed investing”, but in my view, the likelihood of senior debt appreciating vs. equity depends on the circumstances of the particular distressed deal can can not be applied broadly.
CFAI agrees with Schweser. Look under Distressed Debt Arbitrage in the reading on Alternative Investments. Also since credit holders are paid before equity holders, the value of the credit should go up before any improvement in the share price.
would be interesting to see how this trade would have performed on any of the casino or bank stocks in last 3 months!! (short equity, long debt would get fked!!!) Though, I suppose though by definition, those are not truly “distressed” bc no default actually occurred… Or perhaps more likely the text book was written by someone with no actual experience.
Think about a private company where you are pushing the TEV through a waterfall… debt will recover before equity. This is a totally acceptable way to mark to market. The only value to equity will be optionality.
syllabus notwithstanding, i have seen this in practice when you look at the preferred vs common in REITS and insurance companies over the last 5 months. AEG vs AEH is a good example.
Distressed investors buy the senior debt and short the equity to drive a restructuring whereby they can convert the debt to equity at nil prices. However, if eg. due to market risk, event risk, economy improving etc. - “prospects improve”, basically this trade will move completely against you. Waterfall is relevant in restructuring process, in-court or out-of-court. But without a restructuring, stock is a much higher beta vs. senior or junior claims. I guess the language here is “prospects improving”. I’m not debating the short stock / long debt trade, but its success is subject to the event of a restructuring, not “prospects improving” for the company.
well i think that Schweser/CFAI start with the presumption that markets are efficient. if you buy disstresed debt at 10cents/dollar, there is no value in the equity portion unless you get your par value on the bonds. of course that does not mean there is no noise trading that can screw you
if “prospects improve” and debt moves from 50 cents to 70 cents, likelihood that shares (if traded) will move much more. if debt is unsecured and creditors are unable to make claims on the company, debt could even stay at 10 cents while equity rallies!! happens quite often in emerging markets. if your in a restructuring, shares are suspended, etc. then (admittedly) equity will be worth nil, but thats not what the question says.
vandy- your argument isn’t true in real life (i work in distressed). that said, you don’t need to read anything into it as you are doing. CFAI = law for the exam. convertible arbitrage definitely exists in the real world…albeit not like it used to 10 years ago.
Just two questions: 1) so if the co situation worsen, will debt value drop less than equity (based on same reason that debt has priority over equity)? 2) betw the two directions, which will generate a higher net gain? meaning usually the investor buy distressed co in the hope that it will worsen or improve?
agree with OP. i wondered about that myself… if not, then won’t debt outperform under any scenario i.e things worsen or improve.
Is Distressed debt arbitrage = Convertible arbitrage? Or is the difference being convertible debt vs. sr. debt? Thx
convertible arbitrage a leveraged strategy to extract value from underpriced call option with delta hedging, long convertible notes, short bond via asset swap market and delta hedge option
KRochelli - CFAI says if prospects worsen OR improve, debt will always outperform the equity. How is this possibly true in real life? If equity falls more than debt on the way down (this makes sense…), it must regain more then debt on the way up, if prospects improve. Only caveat is that a restructure/recap is triggered at the bottom, which both according to real life and CFAI materials, is entirely subject to restructure, “event risk”, “j-curve” whatever you choose to call it. In for example the REIT market, real life example is GGP, where equity has/will outperform CMBS. However equity lost in JREIT market due to final outcome of the restructure (eg. New City and Re-Plus by Loan Star and Oaktree).
Can I ask, whats the conclusion here? Distressed debtt arb is unlikely to work in the real world?
passthismofo Wrote: ------------------------------------------------------- > Is Distressed debt arbitrage = Convertible arbitrage? Or is the difference being convertible debt vs. sr. debt? ConvertArb is based on volatility and DistressedDebt is based on capital structure - they are different and neither are true arbitrages. HTH.