The Distressed Debt Market and a Possible New ETF on Defaulted and Distressed Bonds Investing in Distressed Securities GARP Chapter Meeting New York May 22, 2014 Dr. Edward Altman NYU Stern School of Business
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
12/01/2000 06/01/2001 12/01/2001 06/01/2002 12/01/2002 06/01/2003 12/01/2003 06/01/2004 12/01/2004 06/01/2005 12/01/2005 06/01/2006 12/01/2006 06/01/2007 12/01/2007 06/01/2008 12/01/2008 06/01/2009 12/01/2009 06/01/2010 12/01/2010 06/01/2011 12/01/2011 06/01/2012 12/01/2012 06/01/2013 12/01/2013 Distress Ratio History 2000 2014 (4/30) 90.00 80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00 Distress Ratio Median Distress Ratio Source: Bank of America Merrill Lynch 4
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 (1Q) $ Billions Estimated Size of the Distressed Bond Market Based on Distress Ratio HY Bond Mkt Distressed Bond Mkt 1,650 1,500 1,350 1,200 1,050 900 887 750 600 450 300 150 102 55 16 5 18 21 9 10 64 73 223 236 158 111 69 46 59 16 168 88 242 120 74 69 - 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 No. of Issues Percent of Total No. of Issues Percent of Total 1800 1600 1400 1200 90.00% 80.00% 70.00% 60.00% 1000 800 600 400 200 0 < 500 500-749 750-999 1000-1249 1250-1499 1500-1749 1750-1999 2000 Spread (bp) 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% Source: Bank of America Merrill Lynch. Data based on the population of distressed credits including only U.S. domiciled companies. 6
Size of Distressed Debt Market 7
Estimated Face And Market Values Of Defaulted And Distressed Debt ($ Billions) 2012 2014 (1Q) Public Debt Face Value Market Value 12/31/2012 12/31/2013 3/31/2014 12/31/2012 12/31/2013 3/31/2014 Market/Face Ratio 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 1 Calculated using: (2013 defaulted population) + (2014 Defaults) - (2014 Emergences) - (2014 Distressed Exchanges). 2 Based on 4.80% of the high-yield bond market ($1.467 trillion) as of 31 M ar. 14. 3 Based on a private/public ratio of 2.0. Source: NYU Salomon Center and estimates by Professor Edward I. Altman. 8
Size Of The US Defaulted And Distressed Debt Market ($ Billions) 1990 2014 (1Q) $4,000 Face Value Market Value $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $- Source: Author s Compilations 9
Default Rate (t+1) % Updated Market-Based Annual Default Rate Forecast Annual Default Rate (t+1) versus Distressed Ratio (t) 14 12 Annual Default Rates (t+1) vs. Distress Ratios (t) (1990-2012) The regression equation is Default Rate = 0.86 + 0.14 * Distress Ratio 10 8 6 4 2 0 0 20 40 60 80 Distress Ratio (t) % y = 0.1412x + 0.8638 R 2 = 0.7647 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% Application Distress ratio (12/30/2011) of 17.88%, forecast P D for 2012 = 3.93% vs. actual of 1.62% Distress ratio (12/31/2012) of 9.88%, forecast P D for 12/31/2013 = 2.65% vs. actual of 1.04% Distress ratio (12/31/2013) of 5.29%, forecast P D for 12/31/2014 = 1.61% Distress ratio (04/30/2014) of 5.03%, forecast P D for 04/30/2015 = 1.57% Sources: Slide 6, Bank of America Securities and authors compilations 10
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) Rate 10.05% 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) Rate *Last Month Change. Sources: Bloomberg & NYU Salomon Center 9.31% 10.91% 9.41% 10.79% 8.71% 11
Market Vectors Index Solutions Launches Altman North America Defaulted And Distressed Bond Index (MVRCOV) (May 21, 2014) Forthcoming ETF on Defaulted and Distressed Bonds 12
Year Comparison of Returns BofA ML Distressed Index Altman-Kuehne Defaulted Bond Index Annual Total Return (%) 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 2009-2013 (5 year) Arithmetic Avg Return Geometric Avg Return 2011-2013 (3 year) Arithmetic Avg Return Geometric Avg Return 16.59 9.82 34.25 28.59 9.72 8.98 13.65 7.11 30.08 25.85 9.41 8.52 Sharpe Ratio (10 year) 0.266 0.222 0.153 0.243 0.22413 8.97 5.59 20.05 18.62 8.86 8.56 9.81 8.23 19.48 18.25 9.30 9.22 9.21 7.40 18.40 17.94 16.83 16.18
Comparison of Returns: Combined Distressed & Defaulted Index with H.Y. Bonds & S&P 500 Year Annual Total Return (%) 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 2009-2013 (5 year) Arithmetic Avg Return Geometric Avg Return 2011-2013 (3 year) Arithmetic Avg Return Geometric Avg Return 15.12 8.64 32.16 27.43 9.56 9.01 Sharpe Ratio (10 year) 0.248 0.243 0.224 14 9.81 8.23 19.48 18.25 9.30 9.22 9.21 7.40 18.40 17.94 16.83 16.18
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 Performance Relative 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 Performance Relative 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
Cumulative Default Rate since First Entering a State of Distress 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. 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. 20