Tim Olson
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45 lines
3.7 KiB
Markdown
45 lines
3.7 KiB
Markdown
---
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description: "Passively buy a diversified portfolio of deeply discounted distressed debt (yield spread >1,000 bps over Treasuries) and hold through reorganization, expecting high returns on the subset of positions that recover."
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tags: [distressed-assets, credit, fixed-income, value]
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---
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# Buying and Holding Distressed Debt (Passive)
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**Section**: 15.1 | **Asset Class**: Distressed Assets (Fixed Income / Credit) | **Type**: Value / Passive
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## Overview
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Distressed securities are those whose issuers are undergoing financial or operational distress, default, or bankruptcy. A common definition of distressed debt is when the yield spread between the issuer's bonds and Treasury bonds exceeds a preset threshold (e.g., 1,000 basis points). This passive strategy buys distressed debt at a steep discount and holds it, expecting (hoping) the company will repay its debt. The portfolio is diversified across industries, entities, and debt seniority levels.
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## Construction / Mechanics
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- **Definition**: distressed debt = yield spread over Treasuries > ~1,000 basis points
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- **Diversification**: spread across industries, issuers, and debt seniority levels (senior secured, senior unsecured, subordinated)
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- **Entry timing**: two common approaches:
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1. At the end of the default month
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2. At the end of the bankruptcy-filing month
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— both aim to exploit overreaction in the distressed debt market at these key dates
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- **Hold**: position is held passively through the reorganization/recovery process
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Passive strategies may also use models (see Section 15.3) to pre-screen assets and predict which companies are likely to declare bankruptcy, selecting only those positioned for successful reorganization.
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## Return Profile
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Only a small fraction of held assets are expected to have positive returns, but those that do provide high rates of return (e.g., full par recovery from a deeply discounted purchase). Returns are highly skewed and non-normal. The driver of returns is successful company reorganization — either an out-of-court debt restructuring or a Chapter 11 bankruptcy reorganization.
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## Key Parameters / Signals
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- **Yield spread threshold**: typically >1,000 bps over comparable-maturity Treasuries as a distress indicator
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- **Entry timing**: end of default month or end of bankruptcy-filing month captures the overreaction premium
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- **Debt seniority**: senior secured debt has higher recovery rates; subordinated debt offers higher upside if the company fully recovers
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- **Industry and issuer diversification**: essential due to high idiosyncratic default risk; a single large default can dominate portfolio returns
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- **Bankruptcy prediction models**: logistic regression or similar models on financial ratios to pre-screen for likely successful reorganizations (see Section 15.3)
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## Variations
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- **Focus on defaults**: buy at the end of the default month, targeting market overreaction to default events
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- **Focus on bankruptcy filings**: buy at the end of the bankruptcy-filing month, targeting overreaction to Chapter 11 filings
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- **Seniority-focused**: concentrate in senior secured debt for higher recovery certainty (lower return, lower variance)
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## Notes
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- Illiquidity: distressed debt is highly illiquid; exit before resolution may require large price concessions
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- Workout timeline: bankruptcy proceedings can take years; capital is tied up for an uncertain duration
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- Legal complexity: debt holders in bankruptcy proceedings face complex intercreditor disputes, cram-down risks, and professional fees
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- Expected value of total portfolio is positive but heavily dependent on the few positions that recover fully
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- This is a passive strategy — the investor does not seek to influence the reorganization process (contrast with Section 15.2)
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