Recovery and Returns of Distressed Bonds in Bankruptcy

Abstract

Linking the trading price of distressed debt after Chapter 11 filing to the ultimate recovery for a large sample of Chapter 11 cases in the past decade, this paper finds that senior bonds realize large returns while junior bonds realize losses during bankruptcy reorganization. This study then provides several explanations for the return anomaly observed in the distressed debt market. Liquidation, bankruptcy costs, and active involvement by hedge funds contribute to the understanding of the returns of distressed bonds. The large negative returns of the junior bonds during bankruptcy reorganization are most likely the result of their initial overvaluation which was due to their lottery-like features.

Keywords: distressed bonds, distressed investing, recovery, Chapter 11