Leveraged Finance and Financial Distress: High-Yield Bonds and Bankruptcy Prediction

Abstract

Leveraged finance—the use of high levels of debt (typically above investment-grade levels) to finance corporate acquisitions, recapitalizations, or growth—has grown into a major asset class, with the global leveraged loan market exceeding $1.4 trillion and the U.S. high-yield bond market exceeding $1.5 trillion. High-yield bonds (rated below BBB/Baa by the major rating agencies) offer higher yields than investment-grade bonds to compensate investors for higher default risk, lower recovery rates, and lower liquidity. Financial distress—the condition in which firms cannot meet or have difficulty meeting their financial obligations—imposes direct costs (legal fees, management distraction) and indirect costs (foregone investment, customer and supplier relationship deterioration) that can destroy substantial value. Altman (1968) developed the Z-score bankruptcy prediction model as the first quantitative discriminant analysis approach to identifying financially distressed firms. This paper reviews high-yield bond markets, credit analysis, covenant structures, bankruptcy prediction models, and the restructuring process.