Revisiting the Altman Definition of Distressed Debt and a
New Mechanism for Measuring the Liquidity Premium of
the High-Yield Market

Abstract

This article undertakes an empirical investigation of the efficacy of the Altman definition, which defines distressed debt as a security trading at a risk premium in excess of 1,000 bps over comparable U.S. Treasuries and whose long-term default rate is expected to be approximately 50%. The authors analyze the constituents of the Merrill Lynch High Yield Master II Index over the 1990–2009 period to test the Altman definition on an out-of-sample basis. They find distressed securities following the risk-premium-threshold component of the definition to experience a long-term average default rate between 48% and 51%, while exhibiting significant short-term variability and mean-reverting characteristics. Additionally, the authors introduce time-to-default characteristics to the Altman definition, finding the median time-to-default for distressed securities to be 14 months, with 90% of the cumulative defaults occurring within 46 months. Furthermore, evidence of convergence between the two Altman definitional components—risk premium threshold and default rate—provides strong support for the definition’s efficacy over long time periods. Finally, decomposition of the option-adjusted spread of the high-yield index finds the presence of liquidity and credit components, with the liquidity component exhibiting a high degree of variability; in contrast, the credit component remains relatively constant over time. Overall, the authors find liquidity risk to be more dominant than credit risk as measured by its contribution to the total variability of the option-adjusted spread of high-yield securities.