CTA Credit Analysis & Debt Markets for Distressed Companies 1 — Questions and Answers
Question 1: In US distressed debt markets, a bond trading at a 'yield to worst' (YTW) above 1,000 basis points over Treasuries is typically classified as:
- Investment grade
- Distressed, indicating the market prices in significant default or restructuring risk (Correct answer)
- Speculative grade but stable
- A risk-free instrument
Correct answer: Distressed, indicating the market prices in significant default or restructuring risk
Bonds trading at spreads exceeding 1,000 bps over Treasuries are generally considered distressed because the market is pricing a high probability of default or debt restructuring.
Question 2: A 'covenant violation' in a loan agreement is significant in a turnaround because:
- It automatically converts debt to equity
- It allows lenders to declare a default, potentially accelerating all debt obligations and triggering a liquidity crisis (Correct answer)
- It requires the company to hire a CRO immediately
- It results in automatic bankruptcy filing
Correct answer: It allows lenders to declare a default, potentially accelerating all debt obligations and triggering a liquidity crisis
Covenant violations give lenders the contractual right to declare default and demand immediate repayment, which can cause a liquidity crisis even if the company is generating positive cash flow.
Question 3: Which credit metric is most important for assessing near-term default risk in a distressed company?
- Debt-to-equity ratio
- Fixed charge coverage ratio (Correct answer)
- Days sales outstanding (DSO)
- Return on invested capital (ROIC)
Correct answer: Fixed charge coverage ratio
The fixed charge coverage ratio measures how many times earnings cover fixed obligations (interest, principal, leases), making it the most direct measure of whether the company can service its debt.
Question 4: 'Distressed debt investing' typically involves:
- Buying investment-grade bonds at a premium
- Purchasing the debt of financially troubled companies at a discount with the goal of profiting from recovery or plan confirmation (Correct answer)
- Investing in stable dividend-paying stocks
- Providing DIP financing exclusively through equity contributions
Correct answer: Purchasing the debt of financially troubled companies at a discount with the goal of profiting from recovery or plan confirmation
Distressed debt investors buy claims at deep discounts and profit if the company recovers or if the restructuring process delivers returns above the discounted purchase price.
Question 5: What does 'loan to own' mean in a distressed investing context?
- A strategy of converting all loans to lease arrangements
- Purchasing distressed debt at a discount with the intent of converting it to equity ownership in the reorganized company (Correct answer)
- A standard mortgage lending strategy
- A technique for hiding debt off the balance sheet
Correct answer: Purchasing distressed debt at a discount with the intent of converting it to equity ownership in the reorganized company
Loan-to-own investors acquire distressed debt strategically intending to receive equity in the reorganized business through a debt-for-equity conversion in the restructuring plan.
Question 6: The 'fulcrum security' in a restructuring is:
- The most senior secured claim in the capital structure
- The class of debt or securities at the level of the capital structure where enterprise value runs out, making it the pivotal class in negotiations (Correct answer)
- The DIP lender's claim
- The class with the largest number of individual holders
Correct answer: The class of debt or securities at the level of the capital structure where enterprise value runs out, making it the pivotal class in negotiations
The fulcrum security class is the one that will be partially or fully converted to equity — holders of this class have the most negotiating power over the final ownership structure.
CTA Credit Analysis & Debt Markets for Distressed Companies 1
In US distressed debt markets, a bond trading at a 'yield to worst' (YTW) above 1,000 basis points over Treasuries is typically classified as: