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The Distressed Debt Market and a Possible New ETF on Defaulted and Distressed Bonds Dr. Edward Altman NYU Stern School of Business Investing in Distressed Securities GARP Chapter Meeting New York May 22, 2014

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The Distressed Debt Market

and a Possible New ETF on

Defaulted and Distressed

Bonds

Dr. Edward Altman

NYU Stern School of Business

Investing in Distressed Securities

GARP Chapter Meeting

New York

May 22, 2014

Distressed Bonds: Corporate Bonds with a

Option Adjusted Spread (OAS) ≥ 1,000bp

Distress Ratio: Percent of High-Yield Bonds

with a OAS ≥ 1,000bp

2

Distress Ratio History

2000 – 2014 (4/30)

Date Distress Ratio

Annual Default Rate

(t+1)

Default Rate(t+1)

/Distress Ratio(t) (%)

12/31/2000 37.33 9.80 26.25

12/31/2001 24.36 12.79 52.52

12/31/2002 31.21 4.66 14.93

12/31/2003 8.40 1.25 14.86

12/31/2004 4.96 3.37 68.05

12/31/2005 5.47 0.76 13.92

12/31/2006 1.62 0.51 31.44

12/31/2007 10.35 4.65 44.97

12/31/2008 81.29 10.74 13.22

12/31/2009 14.53 1.13 7.78

12/31/2010 7.19 1.33 18.43

12/31/2011 17.88 1.62 9.06

12/31/2012 9.88 1.04 10.57

12/31/2013 5.29 n/a n/a

4/30/2014 5.03 n/a n/a

Average 18.55 4.13 22.25

Median 10.11 1.62 14.93

Sources: Bank of America Merrill Lynch & NYU Salomon Center

3

Distress Ratio History

2000 – 2014 (4/30)

Source: Bank of America Merrill Lynch4

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Distress Ratio Median Distress Ratio

Estimated Size of the Distressed Bond

Market Based on Distress Ratio

102

5516 5 18 21 9 10

64 73

223

158

236

6946 59

16

111

887

168

88

242

120

74 69

-

150

300

450

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(1

Q)

$ B

illi

on

s

HY Bond Mkt Distressed Bond Mkt

Sources: Distress Ratio used in calculations from BofAML. HY Bond Market size from NYU Salomon Center estimates.

5

Distribution of High-Yield Bond Issues by OAS

Over Comparable Duration Treasury Bonds,

March 31, 2013

Source: Bank of America Merrill Lynch. Data based on the population of distressed credits including only U.S. domiciled companies.6

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

90.00%

0

200

400

600

800

1000

1200

1400

1600

1800

< 500 500-749 750-999 1000-1249 1250-1499 1500-1749 1750-1999 ≥ 2000

Pe

rce

nt

of

Tota

l

No

. of

Issu

es

Spread (bp)

No. of Issues Percent of Total

Size of Distressed Debt

Market

7

8

Estimated Face And Market Values Of

Defaulted And Distressed Debt ($ Billions)

2012 – 2014 (1Q)

1 Calculated using: (2013 defaulted population) + (2014 Defaults) - (2014 Emergences) - (2014 Distressed Exchanges). 2 Based on 4.80% of the high-yield bond market ($1.467 trillion) as of 31 M ar. 14. 3 Based on a private/public ratio of 2.0.

Source: NYU Salomon Center and estimates by Professor Edward I. Altman.

Market Value

12/31/2012 12/31/2013 3/31/2014 12/31/2012 12/31/2013 3/31/2014

Market/Face

Ratio

Public Debt

Defaulted 252.39 247.90 246.83 (1)

100.96 111.55 86.39 0.35

Distressed 130.06 76.06 70.36 (2)

91.04 53.24 45.73 0.65

Total Public 382.45 323.96 317.19 191.99 164.79 132.13

Private Debt

Defaulted 504.78 495.79 493.66 (3)

277.63 347.06 320.88 0.65

Distressed 260.11 152.12 140.72 (3)

208.09 121.69 105.54 0.75

Total Private 764.89 647.91 634.39 485.72 468.75 426.42

Total Public and Private 1,147.34 971.87 951.58 677.71 633.54 558.55

Face Value

9

Size Of The US Defaulted And Distressed Debt

Market ($ Billions)

1990 – 2014 (1Q)

Source: Author’s Compilations

$-

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000 Face Value Market Value

10

Updated Market-Based Annual Default Rate Forecast

Annual Default Rate (t+1) versus Distressed Ratio (t)

Application

Distress ratio (12/30/2011) of 17.88%, forecast PD for 2012 = 3.93% vs. actual of 1.62%

Distress ratio (12/31/2012) of 9.88%, forecast PD for 12/31/2013 = 2.65% vs. actual of 1.04%

Distress ratio (12/31/2013) of 5.29%, forecast PD for 12/31/2014 = 1.61%

Distress ratio (04/30/2014) of 5.03%, forecast PD for 04/30/2015 = 1.57%

The regression equation is

Default Rate = 0.86 + 0.14 * Distress Ratio

Predictor Coef SE Coef T P

Constant 0.8634 0.4504 1.9170 0.0696

Spread 0.1412 0.0175 8.0626 0.0000

S = 1.5731 R-Sq = 76.5% R-Sq(adj) = 75.3%

Sources: Slide 6, Bank of America Securities and authors’ compilations

0

2

4

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0 20 40 60 80

De

fau

lt R

ate

(t+

1)

%

Distress Ratio (t) %

Annual Default Rates (t+1) vs. Distress Ratios (t) (1990-2012)

y = 0.1412x + 0.8638 R2 = 0.7647

Hedge Fund Distressed Debt Index Returns

2003 – 2014 (4/30)

Calendar Year

Dow Jones/

Credit Suisse Hennessee HFR GAI

Altman-Kuehne

Combined

2003 25.12% 26.79% 29.58% 27.42% 49.30%

2004 15.60% 18.98% 18.89% 18.19% 15.14%

2005 11.75% 9.71% 8.25% 9.34% 1.73%

2006 15.58% 15.78% 15.95% 15.33% 23.38%

2007 8.28% 8.31% 5.07% 7.37% -3.30%

2008 -20.48% -29.28% -25.21% -21.05% -47.52%

2009 20.95% 42.97% 28.54% 24.69% 55.99%

2010 10.26% 15.47% 12.12% 16.35% 17.70%

2011 -4.24% -2.36% -2.42% -1.9% -3.02%

2012 11.77% 13.61% 10.40% 13.8% 7.63%

2013 16.00% 16.16% 14.04% 18.4% 19.37%

2014 (4/30) 3.45% n/a 3.06% 4.0% 5.10%

ΔLM (Apr) * 0.37% n/a 0.26% 0.6% -0.83%

2003-13 Arithmetic Average

(Annual) Rate10.05% 12.38% 10.47% 11.63% 12.40%

Standard Deviation 12.60% 17.89% 15.10% 13.51% 27.71%

2003-13 Compounded

Average (Annual) Rate9.31% 10.91% 9.41% 10.79% 8.71%

*Last Month Change. Sources: Bloomberg & NYU Salomon Center

11

Forthcoming ETF on Defaulted and

Distressed Bonds

12

Market Vectors Index Solutions

Launches Altman

North America Defaulted And

Distressed Bond Index

(MVRCOV) (May 21, 2014)

Comparison of Returns

Annual Total Return (%)

Year

BofA ML

Distressed Index

Altman-Kuehne

Defaulted Bond

Index

Altman-Kuehne

Defaulted Combined

Index

Citi High-Yield Bond

Index S&P 500 Index

2004 24.78 18.93 15.14 10.79 10.88

2005 -15.95 -1.78 1.73 2.08 4.92

2006 42.80 35.62 23.38 11.85 15.80

2007 -12.07 -11.53 -3.30 1.83 5.50

2008 -44.91 -55.09 -47.52 -25.91 -37.00

2009 116.67 96.42 55.99 55.19 26.46

2010 25.41 25.76 17.70 14.32 15.06

2011 -6.61 -3.66 -0.41 5.52 2.11

2012 24.10 2.63 7.63 15.17 15.99

2013 11.66 29.25 19.37 7.22 32.39

2014 (4/30) 2.25 5.18 5.10 3.63 2.56

2014 (1Q) 2.60 7.93 5.98 2.98 1.81

2004-2013 (10 year)

Arithmetic Avg Return

Geometric Avg Return

16.59

9.82

13.65

7.11

8.97

5.59

9.81

8.23

9.21

7.40

2009-2013 (5 year)

Arithmetic Avg Return

Geometric Avg Return

34.25

28.59

30.08

25.85

20.05

18.62

19.48

18.25

18.40

17.94

2011-2013 (3 year)

Arithmetic Avg Return

Geometric Avg Return

9.72

8.98

9.41

8.52

8.86

8.56

9.30

9.22

16.83

16.18

Sharpe Ratio (10 year) 0.266 0.222 0.153 0.243 0.22413

Comparison of Returns:

Combined Distressed & Defaulted Index with H.Y. Bonds & S&P 500

Annual Total Return (%)

Year

Combined Distressed &

Defaulted Index , 50% Split Citi High-Yield Bond Index S&P 500 Index

2004 21.86 10.79 10.88

2005 -8.87 2.08 4.92

2006 39.21 11.85 15.80

2007 -11.80 1.83 5.50

2008 -50.00 -25.91 -37.00

2009 106.55 55.19 26.46

2010 25.59 14.32 15.06

2011 -5.14 5.52 2.11

2012 13.37 15.17 15.99

2013 20.46 7.22 32.39

2014 (4/30) 3.72 3.63 2.56

2014 (1Q) 5.27 2.98 1.81

2004-2013 (10 year)

Arithmetic Avg Return

Geometric Avg Return

15.12

8.64

9.81

8.23

9.21

7.40

2009-2013 (5 year)

Arithmetic Avg Return

Geometric Avg Return

32.16

27.43

19.48

18.25

18.40

17.94

2011-2013 (3 year)

Arithmetic Avg Return

Geometric Avg Return

9.56

9.01

9.30

9.22

16.83

16.18

Sharpe Ratio (10 year) 0.248 0.243 0.224 14

A Possible Active Distressed

Debt Strategy (Volatility-Based

Selections)

15

Annualized Return Distribution (ARD)

Analysis – Original OAS Volatility

Average Annualized Return (Jul -1997 to Dec-2012)

Annualized PerformanceRelative to LO VOL Portfolio

HI VOL portfolio -1.30% -12.22%

LO VOL portfolio 10.92% --

High-Yield Index 6.98% -3.94%

Distressed Index 4.54% -6.38%

S&P 500 TR Index 2.84% -8.08%

Barclays U.S. Aggregate Index

5.94% -4.98%

Source: E.I. Altman, J.F. Gonzales-Heres, P. Chen & S. Shin, “The Return/Volatility Trade-Off of Distressed Corporate Debt Portfolios”, The

Journal of Portfolio Management, Winter 2014, pp 69-85.

16

Annualized Return Distribution (ARD)

Analysis – Normalized OAS Volatility

Average Annualized Return (Jul -1997 to Dec-2012)

Annualized PerformanceRelative to LO VOL Portfolio

HI VOL portfolio 3.46% -11.09%

LO VOL portfolio 14.55% --

High-Yield Index 6.98% -7.57%

Distressed Index 4.54% -10.02%

S&P 500 TR Index 2.84% -11.71%

Barclays U.S. Aggregate Index

5.94% -8.61%

Source: E.I. Altman, J.F. Gonzales-Heres, P. Chen & S. Shin, “The Return/Volatility Trade-Off of Distressed Corporate Debt Portfolios”, The

Journal of Portfolio Management, Winter 2014, pp 69-85.

17

Cumulative Default Rate since First Entering

a State of Distress – Original OAS Volatility

Source: E.I. Altman, J.F. Gonzales-Heres, P. Chen & S. Shin, “The Return/Volatility Trade-Off of Distressed Corporate Debt Portfolios”, The

Journal of Portfolio Management, Winter 2014, pp 69-85. 18

Source: E.I. Altman, J.F. Gonzales-Heres, P. Chen & S. Shin, “The Return/Volatility Trade-Off of Distressed Corporate Debt Portfolios”, The

Journal of Portfolio Management, Winter 2014, pp 69-85.

Cumulative Default Rate since First Entering a

State of Distress – Normalized OAS Volatility

19

Time Dependent Return Analysis –

Normalized OAS Volatility

Source: E.I. Altman, J.F. Gonzales-Heres, P. Chen & S. Shin, “The Return/Volatility Trade-Off of Distressed Corporate Debt Portfolios”, The

Journal of Portfolio Management, Winter 2014, pp 69-85.

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