Bankruptcy Bonanza: Cheap stocks and credit quality

 

When rookie retail investors seem to be on a winning streak, what could possibly be so wrong with taking your COVID stimulus cheque or even your life savings and sinking them into an online brokerage like Robinhood so that you too can invest in Hertz, Chesapeake Energy, Whiting Petroleum and JCPenney stocks? 

If credit quality is any indicator of potential returns from investing in bankrupt companies’ stock, you stand to lose — a lot. 

Source: Verdad bond database. Data for USD corporate high-yield and investment-grade bonds 12/31/96 to 5/30/20. Ratings are market-implied ratings estimated by Verdad, but can be closely proxied using agency ratings. 

According to academic finance theory, riskier investments should earn higher returns. 

Following this logic, since bankruptcy is a huge risk, investing in companies with a high risk of bankruptcy should garner big returns. 

But, that’s where theory runs into reality. A landmark 2008 paper by Harvard economics professor John Campbell documented that “since 1981, financially distressed stocks have delivered anomalously low returns.” 

Historically, investors have not earned the much anticipated higher returns from investing in companies with a high probability of going bankrupt. This isn’t how you save for retirement, but rather a very risky endeavour that could cost you a lot. 

Think you’ll do better buying their bonds? Think again. 

Source: FRED, ICE BofAML Indices. January 1997 to March 2019.

As the chart above shows, investors who buy higher-yield, lower-rated bonds can end up earning lower total returns than if they’d bought lower-yield, higher-rated bonds. This happens when losses from defaults wipe out the higher payments available from those bond issues with heightened levels of distress.

Both equities and bonds exhibit the same strong result: returns tend to go down as bankruptcy risk increases. 

That’s not to say that no one will ever make money in these types of scenarios, but the approach is fraught with risk, so anyone looking to make that bet needs to be mindful of credit quality and trade carefully.

5 months ago

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