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An empirical study of the returns on defaulted debt

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  • Michael Jacobs

Abstract

This study empirically analyses the historical performance of defaulted debt from Moody's Ultimate Recovery Database (1987--2010). Motivated by a stylized structural model of credit risk with systematic recovery risk, we argue and find evidence that returns on defaulted debt co-vary with determinants of the market risk premium, firm specific and structural factors. Defaulted debt returns in our sample are observed to be increasing in collateral quality or debt cushion of the issue. Returns are also increasing for issuers having superior ratings at origination, more leverage at default, higher cumulative abnormal returns on equity prior to default, or greater market implied loss severity at default. Considering systematic factors, returns on defaulted debt are positively related to equity market indices and industry default rates. On the other hand, defaulted debt returns decrease with short-term interest rates. In a rolling out-of-time and out-of-sample re-sampling experiment we show that our leading model exhibits superior performance. We also document the economic significance of these results through excess abnormal returns, implementing a hypothetical trading strategy, of around 5%--6% (2%--3%) assuming zero (1 bp per month) round-trip transaction costs. These results are of practical relevance to investors and risk managers in this segment of the fixed income market.

Suggested Citation

  • Michael Jacobs, 2012. "An empirical study of the returns on defaulted debt," Applied Financial Economics, Taylor & Francis Journals, vol. 22(7), pages 563-579, April.
    • Handle: RePEc:taf:apfiec:v:22:y:2012:i:7:p:563-579
    DOI: 10.1080/09603107.2011.619495
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    References listed on IDEAS

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    1. Fama, Eugene F & French, Kenneth R, 1992. "The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    2. Jacobs, Jr., Michael, 2011. "Empirical Implementation of a 2-Factor Structural Model for Loss-Given-Default," Journal of Financial Transformation, Capco Institute, vol. 31, pages 31-43.
    3. Daniel Rösch & Harald Scheule, 2006. "A Multi-Factor Approach for Systematic Default and Recovery Risk," Springer Books, in: Bernd Engelmann & Robert Rauhmeier (ed.), The Basel II Risk Parameters, chapter 0, pages 105-125, Springer.
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    7. Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
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    11. Mark S. Carey & Michael B. Gordy, 2007. "The bank as grim reaper: debt composition and recoveries on defaulted debt," Proceedings 1056, Federal Reserve Bank of Chicago.
    12. Jon Frye, 2000. "Depressing recoveries," Emerging Issues, Federal Reserve Bank of Chicago, issue Oct.
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    Cited by:

    1. J. C. Arismendi-Zambrano & Vladimir Belitsky & Vinicius Amorim Sobreiro & Herbert Kimura, 2020. "The Implications of Tail Dependency Measures for Counterparty Credit Risk Pricing," Economics Department Working Paper Series n306-20.pdf, Department of Economics, National University of Ireland - Maynooth.

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