The Distressed Corporate Debt Cycle from a Hedge Fund Investor's Perspective

Abstract

This article analyzes the distressed corporate debt cycle from the perspective of a hedge fund investor rather than a hedge fund manager. The authors find that the distressed cycle has an element of memory (repeatability) and can be categorized into three distinct states within a cycle. The authors also find that the Distressed Ratio, which measures the available supply of distressed debt within the high-yield universe, serves as the key factor in predicting distressed hedge fund manager returns. Furthermore, evidence is presented that indicates that regime-switching analytical techniques can be useful in identifying trigger (or inflection) points that lead to state transitions within the cycle. The authors conclude that investors can improve their odds of enhancing return expectations by tactically adjusting their exposure to the strategy based on an understanding of the opportunities and risks afforded by each state within the cycle.