Three break-evens for one bond: getting your money back, earning the target return, and how many months the case can run before the target is gone.
The break-even recovery on a distressed bond is the purchase price compounded at the return you need over the time it will take to collect. A bond bought at 42 needs a recovery of 42 just to return the money, but 60.48 to earn 20 per cent a year over a two-year restructuring, and 72.6 if the case runs three. Against an expected recovery of 70, the cushion is 9.52 points, and the target return survives 33.6 months.
Worked in full in The Distressed Debt Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A distressed bond in or near default trades flat: no coupon accrues, none is paid, and the holder's whole return is the difference between the price paid and the value received when the plan goes effective. That makes time the second input of every distressed trade, as important as the recovery itself. Underwriting a recovery without a date is underwriting half the trade. The useful habit is to express the position as three break-evens, two in value and one in months, and to compare each with the recovery analysis. The recovery break-even tells you how wrong the valuation can be; the months break-even tells you how wrong the calendar can be. Positions that were right about value and still disappointed usually went wrong on the second.
| Input | Value |
|---|---|
| Purchase price, flat | 42 |
| Expected time to recovery | 2.0 years |
| Target return (illustrative) | 20% a year |
| Expected recovery from the waterfall | 70 |
| Share of the recovery in cash | 40% |
| Share in new equity | 60% |
| Discount at which the new equity trades to plan value | 20% |
1. Money-back break-even: the price, 42. Any recovery above it is a gain, but only nominally.
2. Target-return break-even: price × (1 + target)years = 42 × 1.202 = 42 × 1.440 = 60.48.
3. Cushion: expected recovery − target break-even = 70 − 60.48 = 9.52 points, or 13.6 per cent of the expected recovery.
4. Break-even in months: solve 42 × 1.20t = 70, so t = ln(70 ÷ 42) ÷ ln(1.20) = 2.80 years, 33.6 months.
In Excel: =Price*(1+Target)^Years for the recovery, and =LN(Recovery/Price)/LN(1+Target)*12 for the months.
At the expected 70 and two years, the bond returns 29.1 per cent a year and 1.67 times the money. That looks generous until it is set against the two break-evens. The recovery can fall 9.52 points, or the case can run 9.6 months longer than planned, before the position stops earning its target. At the 10 per cent a long-only credit fund might accept, the timeline could stretch to 64.3 months. A position that is safe on recovery and fragile on time is common in distressed investing, because a valuation dispute, a contested plan or a regulatory approval can add a year to a case without changing the waterfall at all.
The form of the recovery moves the break-even again. If 60 per cent of the 70 arrives as new equity that trades 20 per cent below plan value, each point of headline recovery is worth 0.88 when it can be sold. The expected realisable recovery is 61.60, the return falls to 21.1 per cent, and the headline recovery needed for 20 per cent rises from 60.48 to 68.73. The same arithmetic, on a package of cash and takeback notes, is in what an 80-cent recovery is actually worth.
| Purchase price | 1 year | 2 years | 3 years |
|---|---|---|---|
| 30 | 36.0 | 43.2 | 51.8 |
| 42 | 50.4 | 60.5 | 72.6 |
| 55 | 66.0 | 79.2 | 95.0 |
At 42, stretching the case from one year to two adds 10.1 points of required recovery and from two to three adds 12.1, because the target compounds. At 55, a three-year case needs 95.0, close to par, which is why bonds trading in the mid-50s are often a bet on a quick resolution rather than on deep value. A cheaper bond is not safer on time: at 30, a three-year case still needs 51.8, which is 1.73 times the price.
| Target return | Break-even recovery |
|---|---|
| 0% | 42.00 |
| 10% | 50.82 |
| 15% | 55.54 |
| 20% | 60.48 |
| 25% | 65.62 |
Quoting the upside as recovery over price. 70 against 42 is 66.7 per cent of upside, and on a pitch page it looks like a single number. Annualised it is 29.1 per cent over two years, 18.6 over three and 13.6 over four, so the same trade is a strong one or a mediocre one depending on a date no one controls. Put the months break-even beside the recovery break-even in every memo, and run the target return the fund actually needs, after its own fees and funding cost, rather than zero: a position that only gets its money back has lost to the fund's hurdle. The second half of the analysis is whether the recovery itself is right, which depends on the enterprise value the market price implies; that bridge is worked in what enterprise value a distressed bond price implies.
Break-even recovery = price × (1 + target)years, and break-even months = ln(recovery ÷ price) ÷ ln(1 + target) × 12. Here 60.48 against an expected 70, and 33.6 months against an expected 24. The recovery model, the frictions and the timeline, with the break-evens in value and in months, are in the free workbook for this case.
Illustratively, 15 to 25 per cent a year on a single position, higher for less liquid situations. For a bond bought at 42 with two years to recovery, those targets need recoveries of 55.54, 60.48 at 20 per cent, and 65.62 at 25 per cent. Merely getting the 42 back is a zero return and a real loss after funding costs.
Directly, because distressed bonds trade flat and earn nothing while the case runs. A 70 recovery on a bond bought at 42 is 29.1 per cent a year over two years, 18.6 over three and 13.6 over four. Each extra year raises the recovery needed for a 20 per cent return by 10 to 12 points on this bond.
Yes. Reorganised equity is often valued in the plan above where it first trades. If 60 per cent of a recovery is equity that trades 20 per cent below plan value, each point of headline recovery is worth 0.88 in realisable value, and a bond needing 60.48 for its target return needs a headline of 68.73.
This article is one calculation from The Distressed Debt Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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