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 debt becomes lower for given financials. Relative to a perfect information setting, the firm strategically delays default to benefit from a subsequently lower cost of debt. The market’s fair assessment in expectation implies a debt price drop upon default: It reveals the currently worst possible asset value as correct. Debt with higher performance sensitivity and lower information asymmetry mitigates this surprise effect.

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

JEL Classification: G24, G33, D83