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

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.