This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to S&P Global Market Intelligence.
A recent presentation that I viewed made passing reference to a definition of the distressed sector sometimes offered, namely, bonds trading below 70. I take a special interest in this subject, as I originated circa 1990 the more widely accepted definition — bonds trading at spreads-versus-Treasuries of +1,000 bps or greater. The spread-based criterion determines the membership of the ICE BofA US Distressed High Yield Index. In addition, the +1,000-bps-or-greater rule is the basis for calculating another of my ideas, the distress ratio, or the percentage of the high-yield index quoted at distressed levels (see note 1).
The selected quotations in the Appendix corroborate the spread-based definition’s predominance among practitioners. “Predominant” does not equal “universal,” however. For example, a couple of years ago it was reported that analysts at a leading investment bank had “put together a chart to show the universe of high-yield corporate bonds trading below 70 cents, or at distressed prices, over roughly the past decade” (see note 2). In reality, though, it is only in the loan market that a price-based definition of distress can be considered the standard (see note 3).
Inadequacies of a price-based definition
A fundamental problem with defining distress by dollar price is that credit risk is not the sole determinant of a bond’s price. The combination of a below-current-market coupon and a long maturity can produce a sub-70 price on a bond that no one would seriously describe as distressed. This problem will become more severe if, as some market participants expect, interest rates rise sharply over the next few years in response to accelerating inflation. Consider just one of the four conventional-coupon bonds within the investment-grade-only ICE BofA US Corporate Index that were priced below 70 on Nov. 30, 1999. At the time, the ICE BofA US Treasury Index’s effective yield was 6.25%, which compares with 1.15% on Nov. 19, 2021:
Issuer: Rockwell Automation Inc.
Coupon: 5.20%
Maturity: Jan. 15, 2025
S&P Global rating: A+ (not watchlisted for downgrading)
Effective yield: 8.05%
Option-adjusted spread (OAS): +157 bps
Fans of equity-based methods of corporate bond valuation certainly would not have regarded this bond as a troubled issue. On Nov. 30, 1999, ROK stock stood at 19.68 (adjusted for subsequent split). That was up by 67% from its low of 10.60 on Oct. 6, 1998. Over the same interval, Bloomberg’s S&P 500 Telcos index rose by “only” 53%. Granted, in the intervening period, ROK shares got as high as 24.09 on June 30, 1999. In the 22 years since our observation date, however, the company’s S&P Global rating has fallen by just one notch, to A. Given that fact, it would be hard to argue that the ROK 5.20% notes due 2025 were ever a distressed bond, despite qualifying for the designation under the flawed “sub-70 price” definition.
The issues mentioned above do not include three investment-grade zero/cash-pay bonds that were quoted at 30.63 or less on Nov. 30, 1999. Lowest-priced in that trio was the AAA BellSouth Telecommunications Inc. bond due Dec. 15, 2095. At its issuance in 1995, the issue was structured with a coupon of 0% for the first 20 years and 6.65% for the next 80 years. At a yield-to-maturity of 7.75% on Nov. 30, 1999, its OAS was +128 bps, very far removed from distressed territory.
Turning to the high-yield universe and to more recent times, on Nov. 30, 2018, the ICE BofA US High Yield Index’s OAS stood at a well-below-historical-average of +429 bps. On that date, the Bed Bath & Beyond Inc. 5.165% notes due Aug. 1, 2044, qualified as a distressed bond, according to advocates of the sub-70-price definition. Clearly, though, its 66.75 price was heavily influenced by its 23-year maturity. The bond’s BB1 Composite Rating and OAS of +509 bps contradicted the price-based classifiers' distressed verdict. Ditto the 1.39x ratio of total debt to EBITDA at which the company ended the year.
No comparable problem with the spread-based definition
"Ah, but there is a corresponding problem with the spread-based definition of distressed," some alert readers will say. “There are also bonds that sport yields 1,000 bps or more above Treasuries yet are not truly distressed, judging by their greater-than-70 prices.” I invite readers to identify any such example in the current market.
It is true that in periods of peak default risk, some issues will break the +1,000-bps barrier that would not trade that way absent extreme secondary market illiquidity. In some cases, there may be widespread agreement among hardnosed credit analysts that those bonds do not truly have one-year default probabilities of a magnitude ordinarily associated with such spreads.
Note that this problem is not unique to the spread-based distress definition. At cyclical peaks in default risk, some bonds also undeservedly trade below 70. Also at such times, spreads continue to discriminate between unequivocally non-distressed issues, on the one hand, and issues that are either truly distressed or at least “have some hair on them.” On Dec. 15, 2008, when the ICE BofA US High Yield Index’s OAS reached its all-time wide of +2,147 bps, the index included 210 bonds (11.9% of the total) with sub-1,000-bps spreads, ranging as low as +342 bps.
The vast majority of those bonds that were non-distressed by the spread-based definition, 163, had Composite Ratings in the BB category. Even with the U.S. in its most severe economic contraction since the Great Depression and with market liquidity at a low ebb, spreads of +1,000 bps still connoted inferior credit quality within speculative-grade.
Further evidence that a price-based definition does not work for bonds
The inadequacy of the price-based definition was demonstrated on the same Dec. 15, 2008, date by the fact that 30.0% of the issues quoted at spreads of +1,000 bps or more had prices of 70 or higher. It would be difficult to make a case that the Landry's Restaurants Inc. bond was a non-distressed credit at the time. Between 2006 and 2008 the company’s market capitalization plunged by 71.9%. On Dec. 15, 2008, Landry’s CCC2-rated 9.50% notes due Dec. 15, 2014, had an OAS of +6,020 bps, yet its quoted price was 92.5. That fact ensured that the bond would be missed by compilers of distressed issue lists who use price as their criterion.
Let us not neglect what happens under more favorable market conditions such as the present. On Nov. 19, the ICE BofA US High Yield Index’s OAS was +324 bps, which compares with a December 1996-October 2021 monthly mean of +546 bps. The Exela Intermediate/Exela Finance Inc. 10% notes due July 15, 2023 were not distressed, in the eyes of upholders of the sub-70-price criterion, based on its 81.369 price. The issue’s Caa3/D ratings suggested otherwise. Moody’s rating had plummeted from Ba3 just one year earlier (Nov. 19, 2019). S&P Global Ratings downgraded the issue from CCC-, to Selective Default, on Nov. 2, 2021, when the company announced an exchange offer for senior secured term loans and secured notes. In this case, surely, the bond’s OAS of +2,023 bps was a more reliable guide than its price on the question of whether or not it was part of the distressed universe.
Conclusion
In summary, the criterion of spread-versus-Treasuries of +1,000 bps or more is less prone to producing blatant misclassifications than the alternative criterion of a price below 70. I encourage distressed investors to use a spread-based screen in database searches for bond investment opportunities. The same course is advisable for investors seeking to derive the market-implied speculative-grade bond default rate forecast from the distress ratio. Confirmation that most authorities prefer a spread-based definition of a distressed bond to a price-based one can be found in the Appendix.
APPENDIX: Documentation of spread as the preferred mode of defining distress
According to Investopedia: “Typically, the anticipated rate of return on a distressed security is more than 1,000 basis points above the rate of return of a so-called risk-free asset, such as a U.S. Treasury bill or Treasury bond. For example, if the yield on a five-year Treasury bond is 1%, a distressed corporate bond has a rate of return of 11% or higher, based on the fact that one basis point equates to 0.01%.”
Bloomberg explains its Distressed Bonds (DIS) function as follows: “DIS allows you to identify potential U.S. distressed debt investment opportunities by providing a list of bonds that trade at a yield of at least 1,000 basis points above the benchmark government [instrument].”
“A generally accepted guideline is that bonds trading with a yield in excess of 1,000 basis points over the relevant risk-free rate of return (such as US Treasuries) are commonly thought of as being ‘distressed'.”
— Mercer LLC, High-yield and distressed debt: Where are we, where are we going, and how do we get there? (April 2016)
Research assistance by Manuj Parekh and Weiyi Zhang.
ICE BofA Index System data is used by permission. Copyright © 2021 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsem*nt of Lehmann Livian Fridson Advisors LLC's use of such information. The information is provided "as is" and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.
Notes
1. I coined “distress ratio” as a two-noun/no-adjective term analogous to the misery index, the sum of the inflation rate and the unemployment rate. I see no need to alter the phrase, as some do, to “distressed ratio,” which rolls off the tongue less easily.
2. Joy Wiltermuth, “Distress in junk bond prices hit 6-month high in June: J.P. Morgan,” MarketWatch (July 5, 2019).
3. See, for example, S&P Global Market Intelligence, Dec. 22, 2020: “At the end of the first quarter almost 35% of the high yield market by issuer count was trading at a spread above 1,000 basis points, the traditional level at which a bond is considered distressed. Similarly for leveraged loans, at March 31 nearly one-third of that market was priced under 80 (that market’s distressed borderline).” The Mercer document cited in the Appendix confirms a sub-80-price as the standard for defining distress in the leveraged loan market.
