The allowed claim of an unsecured noteholder worked from the indenture: accrued coupon, unamortised OID, no postpetition interest, and what each error does to the return.
An unsecured bondholder's allowed claim is the accreted value of the notes at the petition date plus the coupon accrued but unpaid up to that date. Interest stops at the petition and unamortised original issue discount is disallowed. For 8.00 per cent notes issued at 96, four months after a coupon, the claim is 100.26 per 100 face, and a model that keeps accruing interest through the case overstates it at 114.67.
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A company files for Chapter 11 three years and four months after issuing $200M of seven-year senior unsecured notes. The notes pay 8.00 per cent in semi-annual coupons and were issued at 96. The last coupon was paid on schedule; the next would have fallen two months after the petition. The notes sit in one class of general unsecured claims with $400M of other claims, a secured lender's deficiency claim and trade and lease rejection claims, and the plan gives that class $180M of value. A distressed buyer can buy the notes at 25 and expects the distribution in 18 months. All figures are illustrative.
| Input | Value |
|---|---|
| Notes outstanding, face | $200M |
| Coupon, paid semi-annually | 8.00% |
| Issue price | 96.00 |
| Original term | 7 years |
| Petition date | 3 years 4 months after issue |
| Other general unsecured claims | $400M |
| Value distributed to the class | $180M |
| Purchase price, flat | 25 |
| Time to distribution | 18 months |
Section 502(b)(2) of the Bankruptcy Code disallows claims for unmatured interest, and courts have generally treated the part of an OID not yet amortised as exactly that. The claim is therefore not face but the carrying value under the constant yield method: the issue yield, applied from the issue price forward.
Issue yield: 96.00 = Σ 4.00 / (1 + y/2)t for t = 1 to 14, + 100 / (1 + y/2)14 ⇒ y = 8.78%. Excel: =RATE(14, 4, -96, 100)*2
Accreted value at the last coupon date, 8 periods left: =PV(8.78%/2, 8, -4, -100) = 97.43
At the petition, 0.667 of a period later: 97.43 × (1 + 8.78%/2)0.667 − 2.67 = 97.59
Unamortised OID disallowed: 100 − 97.59 = 2.41
The coupon earned since the last payment date is a matured claim and is allowed. Four months of a six-month coupon of 4.00, on a 30/360 basis, is 120 days of 180, or 2.67 per 100 face. Nothing accrues after the petition date for an unsecured creditor. The two exceptions are an oversecured creditor, which under section 506(b) can accrue postpetition interest up to the value of its collateral, and a solvent debtor, where the question becomes what rate applies.
Allowed claim = accreted value + prepetition accrued coupon = 97.59 + 2.67 = 100.26 per 100 face
Class claim of the notes: 200 × 100.26% = $200.51M
The notes share the class distribution pro rata with every other allowed claim in it. Total claims are 200.51 plus 400.00 = $600.51M. The class receives $180M, so each dollar of allowed claim recovers 29.97 per cent, and the notes recover 29.97% × 100.26 = 30.05 per 100 face. Bought at 25 and paid in 18 months, that is 1.20x the purchase price and 13.1 per cent a year.
Defaulted bonds trade flat: the quote of 25 buys the whole claim, including the 2.67 of accrued coupon. Paying accrued on top of a distressed price, as if the bond were still performing, is a settlement error, not a negotiation.
| Claim used in the model | Claim | Recovery | Annualised return at 25 | Overstatement of recovery |
|---|---|---|---|---|
| Accreted value + accrued to petition | 100.26 | 30.05 | 13.1% | 0.0% |
| Face only | 100.00 | 30.00 | 12.9% | −0.2% |
| Face + accrued, OID ignored | 102.67 | 30.53 | 14.2% | 1.6% |
| Face + accrued + 18 months postpetition | 114.67 | 32.80 | 19.8% | 9.1% |
The face-only shortcut is nearly right here, but by accident: the 2.41 of disallowed OID and the 2.67 of accrued coupon almost cancel. Move the petition to the day after a coupon and they no longer do. The serious error is the last row. Keeping the coupon running through an 18-month case adds 12.00 points of claim; because the notes hold only a third of the class, the recovery does not rise one for one, but it still rises 9.1 per cent, and the annualised return goes from 13.1 to 19.8 per cent. A position sized on the bottom row has been sized on interest the court will not allow.
| Issue price (issue yield) | Petition on coupon date | 2 months after | 4 months after |
|---|---|---|---|
| 100 (8.00%) | 100.00 / 30.00 | 101.32 / 30.26 | 102.65 / 30.53 |
| 96 (8.78%) | 97.43 / 29.48 | 98.83 / 29.77 | 100.26 / 30.05 |
| 92 (9.60%) | 94.80 / 28.94 | 96.29 / 29.25 | 97.81 / 29.56 |
Two bonds of the same issuer with the same coupon and maturity can carry different claims if one was issued at a discount, and the difference is larger the earlier in its life the company files. When comparing tranches, or the same notes from different tap issues, compute each claim separately before dividing the pool.
Most recovery models are built on face, then patched. The usual patch adds accrued interest to the expected emergence date, because that is what the cash flows of a performing bond would have been. It is the wrong date. The claim is fixed at the petition, and only secured creditors whose collateral is worth more than their claim keep accruing. The other half of the mistake is forgetting that the claim enters a pro rata pool: an error in the notes' claim is partly diluted by the other claims in the class, which is why a 14.41-point overstatement of the claim becomes a 9.1 per cent overstatement of the recovery here, and a larger one in a class the notes dominate.
The recovery model in the free workbook for this case runs the waterfall, the frictions and the return on the book's own capital structures. For the step before this one, the value that reaches the unsecured class, see what enterprise value a distressed bond price implies.
Unsecured bondholders generally do not: section 502(b)(2) disallows unmatured interest, so interest stops accruing at the petition date. The exceptions are an oversecured creditor, which can accrue postpetition interest up to the value of its collateral under section 506(b), and a solvent debtor. On the worked notes, 18 months of postpetition interest would add 12.00 points to a claim of 100.26.
Usually not. Courts have generally treated the unamortised part of original issue discount as unmatured interest, so the claim is the accreted value under the constant yield method, not face. Notes issued at 96 with an 8.78 per cent issue yield have accreted to 97.59 per 100 after three years and four months; the 2.41 points still to accrete are disallowed.
No. Once a bond is in default it trades flat, without accrued interest added to the price, because the accrued coupon is part of the claim rather than a separate payment due. A quote of 25 therefore buys the whole claim, here 100.26 per 100 face including 2.67 of prepetition accrued coupon.
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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