Distress and low-grade securities: Issues in distress and illiquidity.

Given the economic importance of distressed firms, this thesis was motivated by an apparent lack of financial economic research examining distressed firms and their securities. The thesis principally focuses on the following two areas: (1) the costs of Chapter 11, and (2) the financial performance of low-grade bonds (i.e., "risky debt"). In addition, the laws and regulations affecting distressed firms are reviewed. Therefore, the main contributions of this thesis are empirical in nature. Regarding the costs of Chapter 11, the evidence presented suggests that they are large. Specifically, the costs of "successful" Chapter 11 are found to be an increasing function of firm size up to a point (i.e., they are a declining function for the very largest firms). Therefore, these findings contrast with previous studies which have found economies of scale for the administrative costs of bankruptcy. This has important implications for capital structure theories which trade-off the costs of bankruptcy with the tax shield advantage of debt over equity. In addition, generally larger costs are found than were found in previous research. Regarding the financial performance of low-grade bonds, the evidence presented suggests that risky debt valuation models which incorporate interest rate risk, in addition to default risk, best describe the return generation process for the three risky bond asset classes examined. The evidence for low-grade corporate bonds, low-grade municipal bonds, and convertible corporate bonds strongly supports this hypothesis. In addition, the evidence examined would suggest that the interaction between the various embedded options in risky debt should be an important element in any risky debt valuation model. Therefore, at a very broad level the thesis has the following two arguments: (1) bankruptcy is very costly; and (2) risky debt displays a return generation process which is very complex. The evidence presented strongly supports both theses