Theory and Evidence

This paper examines defaulted same seniority/same coupon different maturity bonds in relation to capital structure arbitrage. Such bonds should trade at the same level or at predictable spreads. However, this study observes that spreads often widen and become more volatile as the company moves deeper into distress. If abnormal spreads tend to converge over time, a lucrative trading opportunity may present itself. An analysis of a set of 58 defaulted bond issues from 25 firms from 1987 to 2004 will determine if such convergence occurs, and if so, the time period of convergence. The study shows that such pairs of bonds are extremely positively correlated, and that the price of one security is a very good predictor of the price of the other. Results also show that abnormal spreads do converge over time. Given estimated transaction costs, a potentially profitable strategy is possible.