Going for Broke: Restructuring Distressed Debt Portfolios

Abstract

This article discusses how to restructure a portfolio of distressed debt and what the gains are from doing so, and attributes these gains to restructuring and portfolio effects. This is an interesting and novel problem in ?xed-income portfolio management that has received scant modeling attention. We show that debt restructuring is Pareto improving and lucrative for borrowers, lenders, and investors in distressed debt. First, the methodological contribution of the paper is a parsimonious model for the pricing and optimal restructuring of distressed debt, i.e., loans that are under-collateralized and are at risk of borrower default, where willingness to pay and ability to pay are at issue. Distressed-debt investing is a unique portfolio problem in that a) it requires optimization over all moments, not just mean and variance, and b) with debt restructuring, the investor can endogenously alter the return distribution of the candidate securities before subjecting them to portfolio construction. Second, economically, we show that post-restructuring return distributions of distressed debt portfolios are attractive to ?xed-income investors, with risk-adjusted certainty equivalent yield pickups in the hundreds of basis points, suggesting the need for more efficient markets for distressed debt, and shedding light on the current policy debate regarding the use of eminent domain in mitigating real estate foreclosures.