Moody's reports bond prices at default help indicate bankruptcy emergence prices

By Caroline Salls

Pittsburgh, June 15 - Prices of bonds at default are useful indicators of bond prices at emergence from bankruptcy, according to a Moody's Investors Service study.

The study found that, when discounted by return on a single-B index, prices at emergence were on average equal to the price at default. According to the study, most companies are rated B on emergence from bankruptcy.

The market standard for measuring recovery rates is the price of bonds 30 days after default. A comparison of price at default and just prior to emergence reveals the returns investors could have earned holding defaulted bonds through the bankruptcy period, according to the study, which examined 528 bonds issued by 303 non-financial U.S. firms that defaulted since 1982 and emerged from bankruptcy by the end of 2004.

Returns on defaulted bonds were highly skewed, with a median return of zero but a mean return of 17%. When discounting the emergence price by the single-B rate of return, the median return was sharply negative but the mean return was close to zero.

"When the emergence price is discounted back to the default date at the contemporaneous rate of return earned by the index, the mean ratio of the discounted resolution price to the default price is 0.97 and the median ratio is 0.87," Moody's Praveen Varma said in the report.

Overall, the Moody's study found the average return on the defaulted bonds to be similar to the average return earned on the Lehman single-B bond index.

The study also looked at various factors that might be expected to affect the relationship between default prices and emergence prices, such as type of initial defaults, level of seniority in the debt structure and the length of time spent in bankruptcy.

The analysis did not reveal any systematic variation in the ratio of default to emergent prices across these subgroups, suggesting it was unlikely that investors could predict relative returns on bankrupt bonds based on these factors, the study said.

The price at default, however, was a weak predictor of the emergent price, the study showed.

"The use of the default price to predict the discounted emergence price reduces the main absolute forecast error by one-third compared to the unconditional variation around the mean of discounted emergence prices," Varma said.

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