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The Return/Volatility Trade-Off of Distressed Corporate Debt Portfolios

Edward I. Altman, José F. González-Heres, Ping Chen and Steven S. Shin
The Journal of Portfolio Management Winter 2014, 40 (2) 69-85; DOI: https://doi.org/10.3905/jpm.2014.40.2.069
Edward I. Altman
is the Max L. Heine Professor of Finance at the Stern School of Business at New York University in New York, NY.
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  • For correspondence: ealtman@stern.nyu.edu
José F. González-Heres
is a managing director and portfolio manager for the Fund of Hedge Funds portfolios at Morgan Stanley AIP and a member of its investment committee in West Conshohocken, PA.
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  • For correspondence: jose.gonzalez-heres@morganstanley.com
Ping Chen
is a research analyst for the Fund of Hedge Funds portfolios at Morgan Stanley AIP in West Conshohocken, PA.
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  • For correspondence: p.chen@morganstanley.com
Steven S. Shin
is a research analyst for the Fund of Hedge Funds portfolios at Morgan Stanley AIP in West Conshohocken, PA.
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  • For correspondence: steven.shin@morganstanley.com
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Abstract

This article analyzes the returns of distressed high-yield corporate bond portfolios based on the volatility characteristics of their corresponding option-adjusted spreads (“OAS”). Applying Capital Asset Pricing Model (“CAPM”) theory to a portfolio of distressed bonds generates different results depending on whether overall high-yield market OAS volatility is considered. CAPM expectations (higher risk investments demand higher expected returns) are not generally fulfilled in both time-independent and time-dependent space after normalizing the data for overall high-yield market OAS volatility, i.e. the lowest OAS volatility portfolios outperform the highest volatility portfolios. We provide evidence that this phenomenon is a result of the idiosyncratic characteristics of the securities that comprise the lowest OAS volatility portfolios, which generate higher returns because they experience lower default rates and higher terminal values relative to the securities in the highest OAS volatility portfolios. Alternatively, we find that CAPM generally holds under two conditions: 1) in time-independent space where no consideration is given to the OAS volatility of the overall high-yield corporate debt market; and, 2) in time-dependent space where an investor possesses market timing skills. Because persistent market timing skill is rare, investing based on a buy-and-hold strategy, comprised of portfolios of the lowest OAS volatility distressed bonds, may be a practical solution for the long-term distressed debt investor.

TOPICS: Portfolio construction, volatility measures, factor-based models

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The Journal of Portfolio Management: 40 (2)
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Winter 2014
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The Return/Volatility Trade-Off of Distressed Corporate Debt Portfolios
Edward I. Altman, José F. González-Heres, Ping Chen, Steven S. Shin
The Journal of Portfolio Management Jan 2014, 40 (2) 69-85; DOI: 10.3905/jpm.2014.40.2.069

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The Return/Volatility Trade-Off of Distressed Corporate Debt Portfolios
Edward I. Altman, José F. González-Heres, Ping Chen, Steven S. Shin
The Journal of Portfolio Management Jan 2014, 40 (2) 69-85; DOI: 10.3905/jpm.2014.40.2.069
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  • Article
    • Abstract
    • DISTRESSED DEBT MARKET BACKGROUND
    • LITERATURE REVIEW
    • PROCESS
    • TIME-INDEPENDENT ANALYSIS
    • TIME-DEPENDENT ANALYSIS
    • DEFAULT RATES AND TERMINAL VALUES
    • RATINGS MIGRATON
    • NORMALIZING FOR MARKET VOLATILITY
    • MARKET TIMING
    • CONCLUSION
    • APPENDIX A
    • APPENDIX B
    • ENDNOTES
    • REFERENCES
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  • PDF (Subscribers Only)

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