Corporate Debt Markets and Recovery Rates with Vulture Investors

Abstract

Debt pricing models typically ignore the bankruptcy process by specifying recovery rates as an exogenous function of the state space. I develop a parsimonious model in which corporate default induces a transfer of bond ownership away from traditional diversified holders toward risk-averse activist investors (vultures). Vulture funds improve emergence recovery values but demand a premium which increases with the amount of risk they take. The ratio of activist wealth to defaulted debt emerges as the key state variable that drives prices and returns for defaulted debt and expected recovery rates for pre-default bondholders. In empirical tests, this ratio is a significant determinant of risk-adjusted returns and explains 82% of the time series variation in aggregate post-default trading prices. Exactly as the model predicts, the relationship between the activists wealth ratio and returns is strongest firms with assets that are difficult to monetize and for fulcrum classes where the creditors are likely to emerge from bankruptcy holding the newly issued equity. Through its determination of recovery rates, my renegotiation framework can be easily incorporated into a partial equilibrium asset pricing model where it helps to reduce pricing errors relative to models with exogenously-specified recovery rates. The improvement spans the rating spectrum and for 10 year debt in particular, is able to simultaneously match AAA-BBB and AAA-B spreads.