The Information Value of Distress

Abstract

We propose a novel framework for investigating learning dynamics on a competitive debt market. Observing a firm’s survival of apparently distressed periods, the market eliminates asset value estimates that are too low to be consistent with the observed survival. Therefore, the firm's cost of borrowing becomes lower for given financials, which in turn leads to longer survival. Eventually, the expected default threshold persistently undercuts the true default threshold, leading to an underestimation of the firm's default risk. In a specific example calibrated to market data, the credit spread decreases by more than 30%.

Keywords: Asymmetric Information, Learning Dynamics, Strategic Interaction, Quantitative Debt Models

JEL Classification: G24, G33, D83