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Journal of Financial Economics 4 (1977) 239-276. Q North Holland Publishing Company

BANKRUPTCY, ABSOLUTE PRIORITY, AND THE PRICING OF RISKY DEBT CLAIMS

Jerold B. WARNER*

University of Rochester, Rochester, NY 14627, USA

Received October 1976, revised version received January 1977

In practice, there are substantial deviations from the doctrine of ‘absolute priority’, which governs the rights of the fum’s claimholders in the event of bankruptcy. To determine whether or not the possibility of such deviations is reflected in the prices of the lirm’s securities, this study examines the risk and return characteristics of financial claims against firms in court- supervised bankruptcy proceedings. Debt claims against bankrupt firms are indeed ‘risky’, exhibiting levels of systematic risk similar to that of common stocks in general. While some of the findings are anomalous, the data are generally consistent with the view that the capital market ‘properly’ prices risky debt claims to reflect both their risk characteristics and the possibility of departures from the doctrine of absolute priority.

1. Introduction and summary

This study examines the risk and return characteristics of financial claims against firms in court-supervised bankruptcy proceedings. A standard assumption in financial economics is that the firm’s claimholders protect their interests with priority arrangements such as ‘me-first’ rules. Claims against a bankrupt firm - that is, a firm whose market value is less than the face value of its debt currently due-are typically assumed to be paid according to the priority specified in the firm’s original financial instruments.’ Bankruptcy courts in the United States, however, recognize such priority arrangements only in a limited sense. It is not always the case that ‘senior’ claimholders need be paid prior to a class of claimants ‘junior’ to them.

Moreover, at the time a firm initiates bankruptcy proceedings, the rights and priorities of claimholders may actually be uncertain, and subject to determina-

*Assistant Professor, Graduate School of Management, University of Rochester. I wish to thank Eugene Mama, Robert Hamada, Michael Jensen, Edmund Kitch, and Myron Scholes for their helpful comments. I am indebted to Nick Gonedcs and especially Merton Miller for their encouragement and for their criticisms of several previous versions of this work. I have also benefitted from discussions at the University of Rochester and the University of Washing- ton. Financial support from the Center for Research in Security Prices at the University of Chicago is gratefully acknowledged.

‘See, for example, Fama-Miller (1972, pp. 151-153). Scott (1975, 1976, pp. 39+), and Van Horne (1974, p. 5 19).

240 J.B. Womcr, Bankruptcy and the pricing of risky debt

tion by the court. Hence a security of a firm in bankruptcy proceedings represents a gamble whose payoff is tied to both the prospects of the firm and the outcome of the proceedings. This study uses data on securities which traded while their respective firm’s bankruptcies were in progress. A question of major concern is whether the prices of the securities appear to reflect an unbiased market assessment of the final outcome of the proceeding and of the deviations from absolute priority which are likely to occur. The study is organized as follows.

Section 2 discusses institutional aspects of the bankruptcy process in the United States. The firm in bankruptcy proceedings can continue in operation while revamping its capital structure, and need not liquidate. Except in the case where liquidation actually does take place, current bankruptcy procedures permit substantial deviations from the doctrine of absolute priority. A major reason is related to the fact that priorities in large-scale financial reorganization are considered satisfied if the old claimholders are merely given new claims whose face value is equal to the face value of their old claims. Courts have generally not looked at the actual market value of new claims in deciding whether or not the terms of reorganization are consistent with the satisfaction of priorities.

The possibility of deviations from absolute priority should, in an efficient market, be impounded into the price of a security at all times. The security’s price should reflect both the probability of the firm’s going bankrupt and the deviations from absolute priority which are likely to occur when bankruptcy does take place. The study focuses on the cast whcrc the firm is actually in bankruptcy, and where the eventual payoffs on its sccuritics are subject to the rules of bankruptcy with probability one.

Section 3 discusses some gcncral propcrtics of the data assembled to study the securities of firms in bankruptcy. The study conccntratcs on the particular case of railroad securities. A major reason is that data on bankrupt railroads are available more readily and in greater detail than for any other group of comparable size firms. This permits construction of reasonably large samples of securities of bankrupt firms as well as control samples of securities of firms with similar operating characteristics but not undergoing reorganization.

As discussed in section 3, the actual sample consists of 73 defaulted bonds of 20 separate railroads, each of which was in bankruptcy at some time during the period from 1930 to 1955. The average bankruptcy lasted over 12 years. None of the railroads were liquidated. The mean realized return on a portfolio of the sample bonds is over I percent per month for the 1926-1955 period. There is evidence that the distribution of bond returns departs from normality. Conditional on bankruptcy, the average level of systematic risk on the bonds is approximately equal to the risk of the market index of stocks.

In section 4, tests of informational efficiency of the market for the sample bonds are devised and carried out, using the assumption that cxpectcd returns are generated by the two-parameter model of Black (1972). The tests examine

J.B. Warner, Bankruptcy and the pricing of risky debt 241

whether deviations from the absolute priority rule appear to be incorporated into the prices of the affected securities prior to the establishment of the terms of reorganization. Since the financial restructuring and final settlement do not occur at only a single point in time, and because there may be no well-defined ‘announcement dates, it is necessary to observe returns throughout the entire period of bankruptcy.

Using a methodology that permits measurement of risk in event-related time, the systematic risk of the sample bonds appearstorise as bankruptcy approaches. The abnormal performance of the bonds is defined as the difference between their returns and the returns on a control portfolio of securities with approximately the same level of systematic risk. There appears to be significant negative abnormal performance in the month the firm files a bankruptcy petition. Mean abnormal performance in the post-petition period is found to be positive and statistically significant, having a value of approximately one percent per month.

In section 5, the abnormality of returns is also examined in calendar, rather than events time. The abnormality of returns in events time appears to be due to large realizations occurring in the 1940-1942 period, when important legal principles were being established in the field of railroad reorganization. The evidcncc for the 1936-1939 and 1943-1955 periods is consistent with the hypothesis that, for those periods, the sample bonds were ‘properly’ priced and that expected returns were generated by the Black model.

To gain further insight into the 1940-1942 period, several bankruptcy cases which were decided by the Suprcmc Court in the early 1940’s are discussed in section 6. The extent to which the abnormal returns might have been associated with specific dcvclopmcnts in those cases is examined. Abnormal bond returns occur in months surrounding major court decisions pertaining to the railroad reorganizations. Although the evidcncc is inconclusive, it is dificult to reject the argument that, during this period, the prices of the sample bonds did not reflect a proper asscssmcnt of the likely outcomes of the decisions.

Section 7 indicates the major conclusions of the study. With the exception of the 1940-1942 period, the findings arc consistent with the view that the capital market prices debt claims so as to properly reflect the possibility of deviations from the absolute priority rule.

2. Institutional aspects of bankruptcy

The term bankruptcy will be used to refer to proceedings which are under- taken under bankruptcy laws when a corporation is unable to pay or reach agreement with its creditors outside of court. In the United States, bankruptcy is generally under the jurisdiction of the Federal government. Chapter 10 of the Chandler Act applies to most large, publicly held corporations. Section 77, which was enacted in 1933 and which amended the Bankruptcy Act of 1898,

242 J.B. Warner, Bankruptcy and the pricing of risky debt

applies to railroads.’ The sequence of procedures is similar in Chapter 10 and in Section 77 cases.

The bankruptcy process begins when a bankruptcy petition is filed, asking court assistance in settling the firm’s outstanding claims. The petition can be filed by the firm, an indenture trustee, or the firm’s creditors, The court appoints a trustee who then becomes responsible for running the firm. The trustee, in turn, typically delegates his authority to the old management or arranges for the recruitment of new management. The firm can continue in operation during and after bankruptcy, and its assets need not be Iiquidated unless such a decision is made by the trustee and approved by the claimholders and the court. It is important, therefore, to emphasize the distinction between bankruptcy and liquidation, although the two terms tend to be used interchangeably in common speech.

In concert with representatives of the firm’s claimholders, the trustee works out a plan for scaled-down payment of the firm’s debt. The court tentatively approves the plan when it deems it ‘fair and feasible’. The plan is then submitted to the various classes of claimholders for approval. It must be ratified by two- thirds of each class of included claimholder, by value. If the old stockholders are included in the plan, their majority consent is required. If stockholders are not included in the plan, they do not vote.

If the plan is ratified, the court gives its final consent. If the plan is not ratified, the matter is returned to the trustee for further consideration. If the plan is ratified but there are dissenting parties, it can be contested through the Appeals Courts. Bankruptcy terminates when the Appeals process is exhausted. Old claims against the firm are exchanged for cash and, in some cases, for new claims against the firm.

2.1. The absolute priority ruk

If the bankrupt firm liquidntcs and sells its remaining assets, determining the size of the pie to bc cut up by the claimants is a relatively simple matter. In cases where liquidation dots not take place, however, there are additional uncertainties about what is to be divided. This is particularly true where claimholders hold specific liens against properties which were not sold and whose value is in dispute.

Strictly speaking, bankruptcy courts have held that the rule of absolute priority is the proper doctrine for adjusting the rights of claimholders even when there is large-scale financial reorganization without liquidation.’ However, priorities in that case are considered satisfied if the old claimholders are given new claims whose fact value is equal to the face value of their old claims. Courts have

‘The Chandler Act and Section 77 arc Sections 205 and 51 l-676, respectively, of the United Srafcs Codr (1970). The discussions of bankruptcy procedures is based upon the complete text of the Bankruptcy Laws, which can be found in Bunkruptcy Lows oj the UnitEd Swcs (1972).

‘This view was made clear in the Supreme Court’s ruling in Case v. Los Angeles Lumber Products Company 308, U.S. 106 (1939).

J.B. Warner, Bankruprcy and the pricing of risky debt 243

generally not looked at the actual market value of new claims in deciding whether the terms of reorganization are consistent with the satisfaction of priorities.’

The reasons for this view are summarized by Blum (1950). Failure to use the market value of the bankrupt firm as a basis for deciding the rights of claimholders appears to reflect a belief on the part of the courts that the value of the bankrupt firm in the market place may not be a correct measure of its economic worth. Similar positions have been taken by the Securities and Exchange Com- mission, which serves an advisory role in Chapter 10 bankruptcies, and by the Interstate Commerce Commission (ICC), whose approval of a reorganization is necessary in railroad bankruptcies.

For example, in the Wisconsin Central case, a group of bondholders objected to the proposed reorganization plan. They claimed that the market value of the securities they were to be given in satisfaction of their claims was far less than the face value. They argued that claimants junior to them should not receive any payment until they, the senior claimants, received securities whose market value was sufficient to pay off the face value of their old claim. The ICC found their arguments without merit, stating that:

Even if it could be established that the new bonds would not sell at par when the reorganization is consummated, this would not disprove our conclusion as to the intrinsic worth of the bonds, since there is an obvious distinction between such value of a particular security and the price which may be obtainable for it on the stock market at a given time, the latter being influenced by extrinsic factors which have no relation to intrinsic worth. s

Given the view that the market value of the new property is not the relevant measure of the satisfaction of priorities, then under current law, as Blum and Kaplan (1974) have pointed out, the function of absolute priority is merely to set guidelines for the bankruptcy proceedings. The proceedings can be viewed as a set of negotiations between the court, the claimholders, and the regulatory authorities.

2.2. Valuation of the firm

Because the courts do not recognize market values as the correct measure of the economic worth of the firm, an important part of the bankruptcy proceeding deals with the ‘valuation’ of the firm. In Chapter 10 cases, a valuation of the firm is made by the SEC, whose findings are advisory. In Section 77 cases, the ICC certifies the value of the firm and its finding is binding.

4Sce especially Insurance Group v. Denver Rio Grande Western Railroad 329. U.S. 607 (1947).

‘282 ICC 567,572 (1952).

24-l J.B. Warner, Bankruptcy and the pricing of risky debt

The usual procedure for valuing the firm is to capitalize estimated post-tax earnings in perpetuity.‘j Whether or not a particular class of claimholder can be included in the settlement then depends upon the estimated value of the firm. A class will be compensated if the estimated value of the firm is greater than the face value of all claims senior to it.

The consequences of the valuation procedure can best be illustrated with a simple example. Suppose that a firm were unable to pay its debt currently due, which consisted of ‘senior’ bonds with face value of $10 million, and ‘junior’ bonds with a face value of $15 million. Suppose that the firm were to file a bankruptcy petition and the claimholders had decided not to liquidate. The appropriate regulatory agency estimates the value of the firm as a ‘going concern’, based on the firm’s hypothesized new capital structure, an estimate of future post-tax earnings, and an assumed capitalization rate.

Suppose the firm were ‘valued’ at $15 million. Given the valuation, senior bondholders would be given new claims with face value (and estimated ‘intrinsic value’) of $10 million and junior bondholders would be given claims with a face value (and estimated ‘intrinsic value’) of $5 million. Suppose that the actual market value of the frm were $12 million, and that the new claims given senior and junior bondholders turned out to have market values of $8 million and $4 million, respectively. Then the senior bondholders receive $2 million less than they would have reccivcd had the satisfaction of their priorities been based upon market vnlucs, and the junior bondholders receive $2 million more than they would have reccivcd.

2.3. Bankruptcy and market eflcicncy

In the above example, overvaluation of the firm resulted in a redistribution of the firm’s assets to junior claimholdcrs which would not have taken place if the satisfaction of priorities wcrc based upon the actual market value of the firm. There is, in fact, evidence that overvaluation in corporate reorganizations has been more frequent than ‘undervaluation’, and has resulted in substantial deviations from the usual textbook notion of priority.’ However, the con-

%lum (1972) discusses the valuation procedure and choice of capitalization rate in more detail.

‘A study by the ICC (1947) showed that bankrupt railroads were typically overvalued when their reorganization plans were formulated. Newly issued securities of rcorganizcd railroads often sold at discounts of 50 percent and more from their hypothesized values. This resulted in cases where junior bondholders were compensated before senior claimants received the full face value of their debts.

Morcovcr. the common stock of Arms in bankruptcy will frcqucnlly trade at a positive price. Altman (1971, p. 133) reported that 44 pcrccnt of Chapter IO cnscs resuhcd in a positive settlement being given stockholders. We would never obscrvc this if satisfaction of priorities were based on market values, in which cast the stockholders receive nothing, and the value of the bankrupt firm, which is Icss than the face value of its debt currently due, rcvcrts to the bondholders.

J.3. Wurner, Bankruptcy and the pricing of risky debt 245

sequences of such deviations, and whether there might exist alternatives prefer- able to the current procedures, are not at all obvious.

Scott (1975), for example, has recently argued that the toleration of the courts of these departures from absolute priority is inefficient, from a social point of view. Such toleration, he claims, encourages stockholders to follow policies that increase the probability of incurring deadweight costs of the bankruptcy process. It is by no means clear, however, that these costs are greater than those which would have to be incurred to avoid them. In a world where contracting is costly, to insist on financial instruments that specified payoffs completely for every future state of the world and that left no room for subsequent ambiguity is simply to impose costs at the beginning of the process rather than the end. Furthermore, as long as the rules of bankruptcy are known to all participants in the market, any prospective gains or losses based on departures from absolute priority would presumably have been reflected in the prices of securities at the time they were issued, and subsequently as well.* Stockholders, for example, would have to pay for any ‘advantage’ they hoped to derive in the event of bankruptcy by giving the bondholders a larger share of earnings in the times when the firm is not in bankruptcy.

Unfortunately, even if the departures from absolute priority which would occur in the event of bankruptcy were known in advance, it would still be difficult to detcrminc empirically whether the prices of the securities of a firm did in fact reflect the possibility of the dcpnrtures, since the probability of actually going bankrupt is difhcult to infer on the basis of limited sample data. There is, however, one special instance where it is still possible to formulate tests of the efficiency of the market in response to possible deviations from absolute priority: the case where the firm is already in bankruptcy, and where the firm’s sccuritics arc subject to the rules of bankruptcy with probability one. If the market has ‘properly’ priced the sccuritics of such a firm, an investor who buys its sccuritics after the firm cntcrs bankruptcy should not be able to make abnormal profits. The pricing of the sccuritics of firms in bankruptcy is the subject of this paper.

3. The data

3.1. The selecfiorz procedure

A list of railroad bankruptcies among Class I railroads was compiled from Moody’s Transporratiorl Manual and from Interstate Commerce Commission

“This is not to suggest that the rules governing bankruptcy are of no consequence. or that investors will be indilfcrent to alternative sets of rules governing property rights in bankruptcy. Different types of rules and processes may have diffcrenf costs. Current valuation procedures, which allow some deviations from absolute priority, may be optimal, Possible alternatives

to the present system are not our concern here, and are discussed elsewhere by Hum and Kaplan (1974).

246 J.B. Wamer. Bankruptcy and the pricing of risky debt

Annual Reports. A Class I railroad is defined by the ICC as one with revenues (in some pre-bankruptcy period) greater than $1 million per year.

The list consisted of over 50 railroads. It was confined to railroads which both initiated and terminated bankruptcy proceedings between 1930 and 1955. After that time the number of railroad bankruptcies is relatively small. A railroad is considered to initiate bankruptcy proceedings when it files a bankruptcy petition in a Federal court, and to terminate bankruptcy when an exchange of new claims for old ones takes place. The actual exchange follows final approval of the reorganization plan by about six months to a year. The list included all railroads which went through bankruptcy under Section 77 of the Bankruptcy Act, which came into existence in 1933. Railroads which entered bankruptcy between 1930 and 1933 were also included, and most such railroads later filed under Section 77.

The next step was to select specific securities of the bankrupt railroads. The selection procedure concentrated on railroad bonds, since the availability of price quotations on common and preferred stocks was quite limited. For each firm, a list was made of all bonds outstanding in the month the firm filed a bankruptcy petition. In a number of cases bonds were issued during bankruptcy proceedings, and these bonds were excluded.

The procedure generated a list of several hundred bonds. The Bank and

Quotation Record was then used to check the availability of prices on the bonds. In order to minimize potential selection bias, only the characteristics of the securities prior to bankruptcy were considered. To bc included in the sample, a specific bond must have been traded on the New York Stock Exchange after 1925 and at some point prior to bankruptcy. All securities which failed to meet this standard were dropped from the sample. A railroad with no such listed securities was also dropped from the sample.

The selection procedure yielded 73 bonds of 20 separate railroads. This sample

is used throughout the present study. Table A.1 in the appendix indicates the 20 railroads and the specific securities of each which are included in the sample. For each of the 73 bonds, end of month prices are recorded beginning in January of 1926, or whenever the bonds were first listed on the Exchange. End of month prices were available and are recorded throughout the entirc bankruptcy. This included the period between the filing of a petition and up to and including the last full month prior to an exchange of new securities for old ones. About 6 bonds ceased to trade on the Exchange during bankruptcy. However, even in cases where this occurred, quotations were available from the over-the-counter market and were still recorded.

One consequence of the selection procedure, which limits the sample to listed bonds, is that the computed rates of return suffer relatively little from the

LB. Warner, Bmkruptcy and the pricing of risky debt 247

problems caused by non-trading. For most securities, a transaction price is available for the last trading day in a majority of months it is in the sample. In cases where only bid and ask prices are available, the spread appears to be small compared to the variance of the monthly price series.

3.3. The returnsfile

If a transaction price was unavailable for a particular security in a given month, a bid price was substituted for it. A file of arithmetic monthly returns was then created. The earliest sample return is for February of 1926, and the latest is for November of 1955.

Information regarding coupon amounts and dates was obtained from the Bank and Quotation Record and Moody’s Transportation Manual. Other relevant information was obtained from Prentice-Hall’s Capital Adjustments, Commerce Clearing House’s Capital Structure Changes Reporter, and Trafic World. Reference to these sources was made, for example, to determine the exact date at which interest or principal was actually in default. Bonds in the sample typically go into default within a year of, but not necessarily preceding, the filing of a bankruptcy petition.

One additional item was important. During the proceeding, a bankruptcy trustee will order payments, sometimes up to $100 or $200 per $1000 bond, to be made to bondholders. The payments are for back interest which has accrued and is still due. Information on the payments, including the dates and amounts, was compiled.

Returns for each sample bond were adjusted to reflect accrual of interest, coupon payments, and payments of back intcrcst, wherever appropriate. The final returns tile consists of approximately 20,000 monthly returns. The average number of monthly returns per bond is 258. This includes an average of 98 returns prior to and in the month of bankruptcy, and 160 returns for months the firm was in bankruptcy proceedings.

To facilitate the subsequent analysis, a control group of securities of non- bankrupt firms from the railroad industry was also assembled. The group consists of 25 common stocks of railroads which were not in bankruptcy during the 1930-1955 period. These securities represent the entire population of railroad common stocks which were available and which met the non-bankruptcy cri- terion. Monthly returns for these securities were obtained from the Center for Research in Security Prices (CRSP) at the University of Chicago. Table A.2 in the appendix indicates the 25 securities in the control group.

3.4. General characteristics of the sample bon&

The earliest bankruptcy in the sample was initiated in 1930. The last firm to terminate bankruptcy did so in 1955. None of the bankrupt firms liquidated

248 J.B. Warner, Bankruptcy and the pricing of rirky debt

completely. Various mergers, spinoffs, and abandonments of operations did take place during bankruptcy. However, similar activities also took place among non-bankrupt railroads during the same period.

Note that the number of securities in the sample is not constant through time. A number of securities were not outstanding in January of 1926, at the start of the sample period. Moreover, the history of a bond is not traced beyond the

Table 1 Railroad bankruptcies, by year.

Year

No. of firms No. of firms entering leaving bankruptcy bankruptcy

No. of firms in bankruptcy at year end

No. of securities in sample (year end)

19’6 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955

0 0 0 0 0

0 0 0

0 0 0 0 0 0 0

0 0 0 0 0 0 0 0 0 0 0 0

0 0 0

I 0 3 I 3 3 I 3 0 0 2 0 1 1

13 13 15 18 19 20 19 I8 18 15 14 11 8 7 4 4 4

z 1 0

57 57 67 72 73 73 73 73 73 73 73 73 73 73 73 71 66 65 57 53

z 19 13 13 13 9 9 7 0

point where a final exchange takes place at the end of bankruptcy. Since not all bankruptcies ended at the same time, the number of securities in the sample begins to diminish at the point where there are no new securities added and the existing bankruptcies arc settled.

TabIe 1 indicates the number of securities which are in the sample at the end of each calendar year. It also shows the number of firms entering, leaving, or in

3.B. Warner, Bankruptcy and the pricing of risky debt 249

bankruptcy proceedings for the same period. All of the sample &roads entered bankruptcy in the 193CL-1940 period. The sample size increases from 57 to 73 bonds between 1926 and 1930, and remains constant until 1941, when bankruptcies begin to be settled. Table 2 indicates the length of the bankruptcies. The average railroad bankruptcy took over 12 years to settle. The longest sample bankruptcy, that of the Missouri Pacific, took over 20 years.

The settlement which an individual bondholder receives is equal to the value of any new securities he is given plus the cash payments he receives. No data were collected on the prices of the new securities which wereissued and exchanged

Table 2

Duration of bankruptcy.

No. of months Cumulative after bankruptcy No. of &rns probability of No. of petition in bankruptcy termination securities

24 48 72 96

120 144 168 192 216

E 27s

20 19 19 18 16 11 8

: 5 1 0

0.00 73 0.05 71 0.0s 71 0.10 68 0.20 57 0.45 32 0.60 22 0.75 10 0.75 10 0.75 10 0.95 7 1.00 0

Number of months in bankruptcy

Mean 146 Median 143 Minimum 47 Maximum 275

for old ones. However, at the time of exchange the terms of reorganization are well established. Moreover, the prices of the new securities are well known, since they trade on a when-issued basis prior to the exchange. Adjusted for the terms of exchange, the price of the old securities at the time of exchange will be equal to the price of the new securities to be received in the exchange.

Table 3 shows the value of the settlements which were received by holders of the sample bonds, based upon the value of the old securities at the end of the month immediately prior to the exchange. On average, the bondholders received 47.7 percent of the amount of principal plus back interest. In only one case did a

250 J.B. Wurner, Bankruptcy and rhe pricing of risky debt

c1as.s of bondholders receive nothing in the reorganization. The range of payoffs is not markedly discontinuous. The average amount of accrued interest per $1000 bond is $390. During the bankruptcy proceeding, the actual prices of the bonds in the sample range from one percent (i.e. $10 per $1000 bond) to one hundred percent of par value.

3.5. Properties of returns on the sknple bonds

An equally weighted portfolio of bonds is formed for each month from February 1926 through November of 195.5. For a given month, the portfolio

Table 3

Payments on bonds of bankrupt firms.

Fraction of face value plus accrued interest paid in settlement of claim

O-0.09 0.1-0.19 0.2-O-29 0.3-0.39 0.4-0.49

No. of securities 8 6 4 8 18

‘A of sample II.0 8.2 5.5 11.0 24.7

0.5-0.59 O.&-O.69 0.7-0.79 0.8-0.89 0.9-l .O Total

No. of sccuritics 6 1 12 5 5 73

% of sample 8.2 1.4 16.4 6.8 6.8 100

Summary statistics, pcrccntayc of face value plus accrued intcrcst paid

hlinimum Maximum Mean Mcdiun

0.0 100.0 47.7 44.0

consists of all the sample securities whose returns are available. The time series of monthly returns on the portfolio is shown in fig. 1. The variance of the monthly series does not appear to be constant, and its behavior, especially in the 1930’s, is similar to the lindings which Ohicer (1971) reported for the market portfolio for the same period.

Table 4 presents sample statistics on the monthly returns. The mean monthly return on the equally weighted portfolio is 1.3 percent per month for the sample period, with a standard deviation of 9.1 percent. This is similar to the return on the CRSP value weighted index of all NYSE common stocks which, throughout this study, is assumed to represent the market portfolio of risky assets. For that index, the dividend-adjusted mean return is 1.1 percent per month, with a standard deviation of 7.3 percent.

J.B. Warner, Bankruptcy and the pricing of rtiky &bt 2.51

The distribution of portfolio returns appears to depart substantially from normality. The studentized range for the 1926-1955 period is 10.3, greater than the 0.99 fractile of a sample of similar size drawn from a normal population. Similarly, coefficients of skewness and kurtosis both exceed the 0.99 fractile.

Fig. 1. Returns on equally weighted portfolio of defaulted railroad bonds in the sample February 1926 - November 1955.

Table 4

Sample statistics, monthly returns, equally weighted defaulted railroad bond portfolio (iV 6 73).

Sample period

Statistic 2/26-11/55 2/26-12/30 I/31-12/35 l/36-12/40 l/41-12/45 l/46-12/50 l/51-11/55

R. 4&J Minimum Maximum Studcntizcd

range Kurtosis Skcwncss &I s(&

0.013 0.0023 0.091 0.015

-0.316 - 0.054 0.624 0.028

0.0090 0.0009 0.049 0.128 0.137 0.102

-0.246 - -0.316 - 0.141 0.42 0.624 0.372

0.013 0.009 0.061 0.021

-0.184 - ,0.039 0.212 0.089

10.3 5.46 5.2 6.86 5.02 6.49 6.9 11.4 6.06 4.37 8.46 5.42 4.55 5.24 I .x2 -1.47 1.03 1.43 1.12 0.13 1.04 0.01 I O.OOY9 0.0100 0.0034 0.0210 0.013 0.016 0.073 0.063 0.130 0.087 0.039 0.048 0.032

I’ractilcs of a sample drawn from a normal population (N = 60)

0.95 0.99

Studentizcd range 5.5 5.93 Skewness + 0.492 + 0.723 Kurtosis 3.57 3.98

It appears that the distribution is leptokurtic relative to the normal, and skewed to the right. The maximum monthly return on the bond portfolio is 62.4 percent, about twice as great in absolute value as the minimum return.


Since the subsequent measurement of risk and tests of efficiency will rely upon the normality assumption, it is important to note such departures from that assumption, as they tend to diminish the precision of later estimation results9 One explanation for non-normality of the portfolio returns could be the non- stationarity of the return generating process. If the distribution of returns is normal at each point in time but the variance is changing, then the sample statistics of a time series may well give the appearance of non-normality. Table 4 also reports the portfolio returns for six independent subperiods.

Returns for individual subperiods do appear to be closer to normality than those reported for the entire period. The maximum studentized range for any subperiod is 6.9, compared to the value of 10.9 for the overall period. In general, though, even subperiod returns do not appear to be well-described by the normal. The returns seem to be better approximated by a member of the stable symmetric (but non-normal) class of distributions, or some other family of fat-tailed distributions.

The standard deviation of both the bond portfolio and the market rise during the 1930’s. They are approximately equal to each other in the 1931-1935 subperiod. However, the standard deviation of the market falls off before that of the bond portfolio. Note that the return on the bond portfolio is almost 3 percent per month greater than that of the market as a whole in the 1941-1945 period. This topic will be discussed in more detail later.

Statistics for each of the 73 individual bonds in the sample have also been examined. They are rcportcd in Warner (1976). The distributional characteristics of the individual bonds appear to parallel those of the equally weighted portfolio. Howcvcr, the mcnn standard deviation of the 73 bonds is considerably higher than the standard dcvintion of the portfolio, as would be expected if the returns across the bond sample are not perfectly correlated. The mean maximum monthly bond return is almost 100 percent, which is a dramatic indication of how considcrablc were the fluctuations the individual bonds exhibited during the sample period.

3.6. Risk characteristics of rhe sample bonds

The two parameter asset pricing model of Black implies that the relevant measure of the risk of an asset is its ‘systematic’ risk.” This measure of risk is defined as the ratio of the covariance of the return on an asset with the return on the market portfolio to the variance of the return on the market portfolio of risky assets. Given the assumptions that the return-generating process is stationary and multivariate normal, the ‘market model’ provides an appropriate

%x MacBeth (1975, pp. 25-28) for a discussion of the robustness of the normality assumption when the true distribution departs from normality.

‘%cc Jensen (1972) for a discussion of the capital asset pricing model, of which the Black model is one particular version.


framework for estimating the systematic risk of an asset or portfolio.” Table 5 provides market model estimates of the risk, B, of the equally weighted portfolio. The estimates are derived from ordinary least-squares regression of the monthly returns on the bond portfolio against the return on the market index of common stocks. In discussing the results, it should be noted that the process generating the data appears to be neither stationary nor multivariate normal. For that reason, the point estimates of B and t-statistics be interpreted with caution.

for equally weighted portfolio for entire sample period and each subperiod. For the 1926-1955 period, the

note that the value the 1926-1930 period,

Table 5

Estimates of market risk for the bond portfolio, &r = a+fi i&,r+E.r,

Sample period

Statistic 2/2fGlI/SS 2/26-12/30 l/31-12/35 I/36-12/40 l/41-12/45 l/46-12/50 l/51-11/55

a 0.005 0.0016 0.0020 -0.030 0.040 0.001 0.004 t(d) 1.2s 0.83 0.16 -0.29 2.79 0.15 1.34 B 0.75 0.077 0.697 I .25 0.805 0.9008 0.32 0) 14.3 2.51 7.65 8.82 2.24 8.53 4.17 SW 0.072 0.015 0.09 0.039 0.096 0.043 0.019 Minimum t! -0.17 -0.048 -0.161 -0.166 -0.157 - 0.086 -0.035 Maximum h 0.492 0.029 0.306 0.415 0.318 0. I33 0.062 S.R. (e’s) 9.19 5.13 5.18 7.26 4.94 5.06 5.1 R’ 0.377 0.099 0.503 0.573 0.098 0.51 0.537

to any of the bankruptcies, is close to 0. A g of 0.08 for non-defaulted corporate bonds is comparable to the findings reported by Weinstein (1975) for industrial and public utility bonds over the period 1962-1974.

The systematic risk of the portfolio rises in the 1930’s, as does the residual standard deviation. For the entire sample period, returns on the market explain about 38 percent of the variation of the bond returns. The figure is, however, much lower in the 1926-1930 and 1941-1945 periods.

Table 6 displays sample autocorrelations and Q-statistics for the raw returns.” There is evidence of serial dependence in the returns. It is most apparent for the 1926-1935 period, where the first-order autocorrelation coel%cient is 0.40.

“Fama (1976, chs. 2-4) discusses the theory and estimation of the market model in more detail.

I’For a discussion of the methodology of statistical time series analysis, see Box and Jenkins (1970).

254 J.B. Warner, Bankruptcy wd the pricing of risky debt

The presence of serial dependence may well be indicative of changes in the mean of the return generating process which were taking place at that time.

For each bond in the sample, market model regressions have also been estimated for two event-related periods. The first period includes all months prior to and including the month in which the firm files a bankruptcy petition. The second period begins after the bankruptcy petition and includes all subsequent months for which an observation on the bond’s return is available. For the 73 sample bonds, the mean estimate of B changes dramatically, and more than doubles between the two periods. The increases in estimated systematic risk appear to take place across the entire bond sample, and the median estimate of j3 also approximately doubles between the two periods. Conditional on the filing of a bankruptcy petition, the average estimated systematic risk is 1.07.

Table 6

Autocorrelations and Q-statistics for equally weighted bond portfolio returns.

Period Pl Pz Pa s(B) Q(3)

2126-l I/55 0.11 0.07 -0.11 0.05 10.9’ 2126-12135 0.40 -0.18 0.09 0.09 15.9’ 1/36-l l/55 -0.04 0.07 -0.01 0.06 1.57

‘Greater than critical value at 0.05 Icvel.

4. Risk, return, and market efficiency

4.1. Bankruptcy and the riskiness of tire bonds

To get a more prccisc idea of changes in risk around the time of bankruptcy, a technique similar to that of Ibbotson (1975) can bc used.” The methodology is a crucial part of the later tests for market effrcicncy. Suppose a portfolio of sample bonds were formed under a trading rule of the following form. Letj bc an integer which is the same for every sample bond. An equal dollar amount of each sample bond is purchased at the beginning of thejth month prior to or after its respective firm’s bankruptcy petition, held for one month, and sold at the end of that month.” Thus, a value ofj equal to 0 represents the month in which the firm files a bankruptcy petition. Forj equal to, say, - 1, the trading rule yields

“See Ibbotson (1975) for a discussion of the random coefficients literature and the properties of the model.

r4An alternative trading rule might be to invest an equal dollar amount in each railroad, with the amount per railroad then being allocated to that railroad’s bonds. However. such a trading rule, which treats the bonds of a given railroad as one security, would not be sensitive to transfers which took place between bondholders of a given railroad.

J.B. Warner. Bankruptcy and the pricing o/risky debt 255

a portfolio whose components consist of the returns on each sample bond in the first month before its respective firm filed a bankruptcy petition.

In the bond sample, the calendar dates of bankruptcy differ across railroads. Even though j is tied, the jth month before bankruptcy will occur in a diffexent calendar month for each railroad. For example, the Erie Railroad filed a petition in January of 1938, and the Missouri Pacific filed a petition in March of 1933. In implementing the trading rule for, say, monthj = - 1, the returns of interest would be those observed on the Erie Railroad in December of 1937 on the Missouri Pacific in February of 1933. Thus, for a given event-related month j, the trading rule implies examining a set of returns which, in general, will be drawn from different calendar months for different railroads.

For each sample bond return in month j, there will also be a return on the market index for the corresponding calendar month.’ ’ For example, the market return which corresponds to the month - 1 return on Erie Railroad bonds is the market return in December of 1937. The market return which corresponds to the month - 1 return on Missouri Pacific bonds is the market return in February of 1933. Again, returns on the market index which correspond to the sample bond returns for any monthj will be drawn from different calendar months for different railroads.

For any event-related monthj, up to 73 paired observations on a bond return and a market return are available. The systematic risk implied by the trading rule can be estimated by a regression of the following form:

4, = ~,+@L,+4,* i=l,2 ,..., N, (1)

where N is the number of bonds whose returns are available for month j (N 6 73); B,, is the return on the ith security in thejth month; k?,,,, is the return on the market portfolio in the same calendar month, and ?,, is an estimate of the stochastic distrubance on the ith security for that month.

j, can simply be thought of as the estimated systematic risk on the equally weighted portfolio implied by the trading rule. By using this procedure and estimating (1) for different j- that is, for each of a number of different event- related months - it will be possible to examine changes in bond risk around the time of the bankruptcy petitions.

For any portfolio comprised of securities in the control sample of 25 common

“It should be noted that even if the returns on Ihe market portfolio are independent through time, the vector of &‘s we obtain for thejth month will not be. This is because some firms have more than one security in the sample. Since the securities of a given firm have the same calendar month of bankruptcy, the k?,,,, will be identical for those securities no matter which event-related month we specify. Compared to a situation where no two securities share a common bankruptcy dale, this will lend lo dccreasc Ihc precision of our estimation results. However, the estimate of B will be unbiased as long as the R,,,, and P,, are independent. The unbiasedness will hold even when the returns (or disturbances) on the securities of a given firm are contemporaneously correlated.

256 J.B. Warner. Bankruptcy ad the pricing of risky debt

stocks of non-bankrupt railroads described in section 3, it is also possible to compute estimates of B, for the same event-related month. For any such ‘control portfolio, a time series of monthly returns can be calculated. Then for each bond whose returns are available for a given event-related month, there is a corresponding return on the control portfolio and on the market for that calendar month. As with the bond portfolio, up to 73 paired observations on the control portfolio and the market portfolio are available for thejth event related month, and (1) can be estimated using the observations on the control portfolio as the dependent variable.

&, from this regression will then correspond to the systematic risk of the control portfolio for month j. By using this procedure for the months around the filing of bankruptcy petitions, it will be possible to determine the extent to which changes in bond risk were also characteristic of securities of non-bankrupt railroads. To examine the extent to which risk changes took place in control portfolios which differed in their levels of systematic risk, the securities of the control sample can be formed into several portfolios, each of which had a different level of systematic risk.

4.2. Estimating the risk of the bond portfulio and the conrrol portfolio

Two portfolios are formed from the common stocks of the control sample. The first portfolio consists of ‘low B’ railroad sccuritics. The second portfolio consists of ‘high B’ railroad securities. The composition of each portfolio is dctcrmincd by a market model rcgrcssion for each of the 25 stocks in the sample for the 1926-I930 period. The stocks arc ranked according to their estimated B’s, and, based on the rankings, two equally weighted portfolios are formed. The first consists of the 13 highest-f? securities. The second consists of the 12 lowest-B securities. Throughout this section, they will bc rcfcrred to as the high-B and low-B control portfolios.

For the equally weighted bond portfolio, B’s are estimated for each of 354 consecutive event-related months. The first month is the 100th month before the filing of a bankruptcy petition. The last month is the 253rd month following that event, B’s are then estimated for the high- and low-B control portfolios for the same period.

In fig. 2, the estimated systematic risk of each of the three portfolios for each event-related month is plotted. The B for a given month is assumed to be equal to an average of the estimated B’s for the previous ten event-related months.’ 6 Prior to bankruptcy, the systematic risk of the bond portfolio appears to exhibit a large incrasc, with the estimated B of the bond portfolio rising from 0.29

‘*No& that if the true B is lixcd or changing gradually through events time, averaging will increase the precision of the estimates, even though the procedure is likely to induce autocorrelation in the averaged series.


in the 90th month prior to bankruptcy to 0.96 in the month a bankruptcy petition is filed. The t-statistics on Bare generally significant, although, it should benoted, they are only half those for each of the control portfolios.

One explanation for the increase in B relates to changes in the firm’s capital structure which may be taking place prior to bankruptcy. As bankruptcy approaches, the common stock is likely to decline in value by more than the value of the firm’s debt. As this happens, the bondholders’ claim becomes more and more like an equity claim. When bankruptcy finally occurs the firm will be com- posed primarily of debt, and the debt will have risk characteristics similar to those of the common stock of an equivalent unlevered firm.

As fig. 2 shows, the B’s of the control portfolios also appear to increase. The estimates of B for the control portfolios increase from 0.87 in month ‘-90’ to 1.10 in month ‘O’for the low-Bportfolio, and from 1.17 to 1.87 for the high-B portfolio. r’ Fig. 3 shows t h residual standard deviation for each port- e

folio in event-related time. The residual standard deviation of the bond portfolio is larger than that of the control portfolios, and also tends to rise as bankruptcy approaches.

4.3. Bankruptcy and market efficiency

One way of testing whether the sample bonds were ‘properly’ priced to reflect the possibility of deviations from absolute priority is to see whether it would have been possible to earn abnormal profits by trading the bonds. Suppose, for example, that the market had consistently misgucssed the settlement which a

“This behavior is not surprising. The riskiness of all railrod firms may be moving together

through time. If that is the case. we would expect the risk characteristics of junior securities such as common stock and dcfnultcd debt IO exhibit similar behavior.


.45 T BOND SOKT‘OLlO I I

Fig. 3. Residual standard deviations - cvcnts time.

particular type of security would receive. Suppose the market always assumed that the scttlcmcnt would be lower than it actually turned out to bc. Then when prices were set, they would have been too low, and expected returns would have been too high, compared to a situation where the market were able to make an unbiased forecast of the terms of settlement. Abnormal profits would have existed for individuals who bought such securities.

One way to establish a benchmark by which to measure whether returns on the bonds were ‘too high’ or ‘too low’ is to assume that security returns are generated by the Black model. I8 The model implies that, in equilibrium, prices

“Indepcndcnt tests of the Black model are presented clscwherc. Jensen (1972) discusses Ihe literature on empirical tests of the model, and Fama and MacBeth (1973) and MacBeth (1975) provide additional evidence in support of it. A recent critique of the tests is contained in Roll (1976).

3.B. Warner. Bankruptcy and the pricing of risky debt 259

are set so that the expected return on the nth asset or portfolio will be given by the following relationship:

where 8,1 is the rate of return on the asset n, 8,,,, is the return on the market portfolio m, 8,, is the return on the asset z such that B,, = 0, and B,, is the systematic risk of n in portfolio m.

If (2) is a correct specification of the return generating process, then the expected return on securities of firms in bankruptcy should be equal to the expected return on securities of non-bankrupt firms with the same level of systematic risk. The expected value of the difference in risk-adjusted returns should, in an efficient market, be equal to zero.

4.4. Measuring the performance of the sample bonds

Keeping in mind the need to control for differences in risk, the performance of the bonds of firms in bankruptcy is now examined. The relevant measure of abnormal performance is taken to be the difference between the return on the bond portfolio and the return on another portfolio of securities with the same lcvcl of systematic risk as that of the bonds. Black and Scholcs (1973) and Goncdcs, Dopuch and Penman (1975) have employed similar performance measures.

The cquivalcnt-risk portfolio against which the bond returns arc to be compared could, in principle, bc sclcctcd at random. It need not be made up of sccuritics from the railroad industry. However, as shown below, realized returns on diffcrcnt sccuritics of firms in the railroad industry arc highly correlated. The magnitude of such an industry cffcct may well be important in the case of railroads. For example, World War II overlaps part of the post-petition period for 19 of the 20 sample railroads. During the War, many railroad firms expcri- cnccd large increases in revenues and profits which may have been unanticipated. Over the 1941-1945 period, the mean return on the 25 common stocks of the non-bankrupt railroads was 4 percent per month, compared to 2 percent per month on the market index.

If the sample bonds exhibited performance similar to the railroad common stocks and the market index were used as the benchmark, an ‘abnormal’ bond performance might in fact have been no different from that of other securities of firms in the same industry. In order to take into account railroad performance in general, the benchmark portfolio against which the bond returns are measured is the railroad common stock sample discussed earlier. Note that if no industry e!Tect exists and such a procedure is still used, no systematic bias is introduced,

260 J.B. Warner, Bankruptcy and the pricing o/risky debt

and the methodology is roughly equivalent to randomly selecting a control portfolio of common stocks.”

For each month from 100 months prior to the bankruptcy petition through the 253rd month following the petition, two portfolios are formed. The first portfolio is the equally weighted bond portfolio, formed according to the trading rule discussed earlier. The second portfolio consists of the common stocks of non-bankrupt railroads. It is constructed as follows.

As discussed earlier, for each event-related month there is an estimate of B for the bond portfolio and for the high- and low-B control portfolios of common stocks. In each month, a risk-adjusted portfolio of common stocks with the same level of risk as the bond portfolio is formed. For a given month, the portfolio is formed by calculating a unique set of weights summing to one which, when applied to the B’s of the two control portfolios, yield a new portfolio with the same B ;1s that of the bond portfolio.

Since the B’s of all three portfolios are measured with error, the set of weights derived is an estimate of the correct weights which would be derived, given the true B’s. The weights may imply short-selling, and may change from month to month. For each month, the return on the risk-adjusted portfolio is computed by applying the calculated set of weights for that month to the returns on the low- and high-B control portfolios.

4.5. Pcrfortnancc in de nrodr of bankruptcy

Bcforc moving to a discussion of post-petition performance, it is of interest to invcstigatc the cxtcnt to which the market anticipates bankruptcy. Some light can bc shed on that question by looking at the bond returns in the month the firms file bankruptcy pctitions. Table 7 and fig. 4 summarize bond pcr- formance in that month. Mean returns in month ‘0’ are negative, and lower than in any other month. The mean value is -0.092, that is, -9.2 percent. The diffcrcncc between the return on the bonds and on the risk-adjusted portfolio is - 0.119, with a r-statistics of - 8.37, based upon the previous 20 observations.

The fact that the returns in month ‘0’ are abnormally low has several possible interpretations. One explanation is simply that the market did not fully anticipate

“Wne potential problem with the methodology is that fewer securities are available for inclusion in the industry specific control portfolio than would be if all securities in the market were used. A loss in the efficiency of the tests might result from the small control samples which must be used. However, that does not appear to be an obvious problem here. For cxamplr. the monthly standard deviation of return on the low-Dcontrol portfolio of I2 stocks, which has an estimated systematic risk of approximately I. is about the same as that of the market portfolio over the sample period. Since returns on the sample bonds arc more highly corrclatcd with the low-0 control portfolio than with the market, the standard deviation of the difference bctwccn the bond portfolio and the low-B control portfolio will actually be less than that of the difference between the bond portfolio and the market index.

J.B. Warner. i3ankruprcy and the pricing of risky debt 261

that the railroad would file for bankruptcy at that time. Presumably, even if there are large costs associated with the bankruptcy process, the filing itself could not explain a month ‘0’ effect if the market had previously known the true state of the company’s affairs. However, since the filing of a bankruptcy

Table 7

Average security performance in months a sample firm files a petition, (N = 73).

Category Mean return f-statistic’

Bonds of petitioning -0.092 -1.87 railroad

B-adjusted control 0.030 0.86 portfolio

Ddference -0.119 - a.37 Market index 0.026 0.72 Bonds of non-petitioning

railroads which are in the sample of 20 0.037 0.75

‘Uascd upon previous 20 monthly observations.

Fig. 4. Differcncc between returns on bond portfolio and the risk-adjusted stock portfolio - events time,

petition was voluntary for our sample railroads, the petition might simply be conveying new information about management’s view of the prospects For the firm.

Bankruptcy could also occur in the same month that other negative information about the firm or industry becomes known. Some light can be shed on this

262 J.B. Warner. Bankruptcy and the pricing of risky debt

possibility by examining the control portfolio of railroad stocks. As table 7 shows, the B-adjusted control portfolio has a mean return of 0.030 in month ‘O’, with a Z-statistic of 0.86, indicating that returns on the common stocks of the control railroads were not unusual. Also, in months when one of the sample of 20 bankrupt railroads tiles a petition, the bonds of the other 19 raihoads have a mean return of 0.037, with a t-statistic of 0.75.

Thus the large decline in month ‘0’ cannot be attributed to adverse develop- ments in the railroad industry. Particular bankruptcy announcements do not appear to be associated with adverse industry returns. These findings also suggest that bankruptcy had no ‘contagion effect’ since the other railroads do not appear to be adversely affected by a railroad’s bankruptcy petition. While bankruptcy may be a rare event, it appears that its occurrence did not lead to a reassessment of the prospects for other railroads which resulted in a downward revision of their prices.

If the month ‘0’ effect were a lagged response to information already available, a ‘contagion effect’ would have been expected, since the ‘ignored’ information might pertain to all railroads or to all firms in the economy. Since there was no such effect, the results suggest that the abnormal returns are more likely to be the result of new information which becomes available about the particular firm.

4.6. Prc- cud post-petition pcrfornrcmrc

To complete the picture, fig. 4 shows the diflcrence between the returns on the bond portfolio and on the risk-adjusted stock portfolio for 90 months prior to and 150 months subscqucnt to the filing of the petition. Table 8 compares the bond returns with those of the risk-adjusted portfolio. In the 90 month period prior to bankruptcy, the mean return on the bonds is signiftcantly less than that of the stock portfolio. The mean difference is -0.006 per month for 90 months prior to bankruptcy. This amounts to a fall of over 50 percent in the value of the bonds.

These findings, however, need not imply consistent mispricing. There is a strong selection bias when looking at pre-bankruptcy performance since the sample consists of the bonds of companies that did fail. The more appropriate time for assessing mispricing is the post-petition period, since market etliciency would imply that, conditional on bankruptcy, the expected value of the difference in risk-adjusted returns should not be significantly different from zero. However, this does not appear to be the case.

As table 8 shows, the mean return on the bonds in the post-petition period is 1.91 percent per month. This compares to a mean return of 0.86 percent per month on the risk-adjusted portfolio. The mean value of the difference between the returns on the bonds and on the risk-adjusted portfolio, which is our measure of abnormal performance, is 1.05 percent per month, with a t-statistic of 3.55.

J.B. Warner. Bankruplcy and rhc pricing of rrjky debt 263

While the mean difference does vary across different post-petition periods, it is always positive and statistically significant. This indicates that post-petition returns on the bonds were abnormally high.

5. Tests for the abnormality of returns in calendar time

If the methodology for measuring abnormal performance is correct,*’ then the finding of abnormal post-petition returns is inconsistent with a world in which the capital market was efficient in pricing the bonds. It appears that significant profits could have been earned by buying the bonds in the month after the firm filed a bankruptcy petition. In order to determine whether the

Table 8

Monthly mean returns on the bond portfolio and the risk-adjusted control portfolio.

Period

Statistic -901-l l/l00 lOI/ 2011253 l/253

R. s(Rs) S.R. RC d&l S.R. .-- (Rn- Rc) dR. - R,:) I-stati!;tic

0.0003 0.0207 0.0205 0.0313 0.0409 0.0377 5.95 4.56 4.95 0.0063 0.0133 0.0145 0.0344 0.0278 0.0293 5.57 5.111 4.95

- 0.006 0.0094 0.0060 0.0345 0.0305 0.0312

- 1.64 3.0x I.92

0.0132 0.0191 0.0249 0.0368 5.38 5.21

- 0.0079 O.cQSh 0.0768 O.OUO 7.53 13.16

0.0210 0.0105 0.0833 0.0470 I.83 3.55

abnormalities wcrc prcscnt throughout the snmplc period or only at particular times during that period, the performance of the sample bonds over calendar time is now examined.

For each month beginning in December of 1935, and continuing through November of 1955, three equally wcightcd portfolios are formed. The first portfolio consists of a11 sample bonds of firms that have already filed a bankruptcy petition in some previous month. The proccdurc begins in December of 1935 because that is the first month for which there are 60 observations on the

“Since the sample bonds on wcrnge had a post-petition R of 1.07, approximately equal to that of the market index, the methodology can be checked by comparing the bond returns lo those of the market index. However, the mean difference between the returns on the bonds and the CRSP index is 0.6 percent per month in the post-pelition period, with a r-statistic of 2.93. The bond returns were abnormally high compared Lo both the control portfolio and the market index, and our finding of abnormality does not appear to be merely the result of using a particular type of control sample.

264 J.B. Warner, Bankruptcy and the pricing ofrisky debt

portfolio return. The second portfolio consists of the high-B control securities, and the third consists of the low-B control securities.

The systematic risk of each portfolio is then estimated for each month, based on the 60 previous monthly observations. Given the risk of the bond portfolio in each month, a risk-adjusted portfolio of stocks is formed. Again, this is done by finding the appropriate set of weights on the high-B and low-B portfolios of sample stocks.

For each month beginning in December of 1935, the difference between the return on the bond portfolio and the return on the B-adjusted control portfolio, a difference denoted by (Rb-R,), is examined. This is the abnormal performance measure used earlier when the bond returns were examined in event-related time. In addition, the quantity C’& (Rb--R,) is computed for each month.

For month m, this is the cumulative ditTerence between the return on the bond portfolio and the risk-adjusted control portfolio.

If the individual monthly differences are serially independent and identically distributed, then the cumulative difference is a random walk. The expected value of the difference is equal to zero in the absence of abnormal performance. A positive and statistically significant value of the mean of (Rb- R,) is indicative of positive abnormal performance.

The results arc summarized in table 9, which shows the value of the difference bctwccn the return on the bond portfolio and the risk-adjusted control portfolio. It also shows the vnluc of the cumulative diffcrcncc for specific months. The values of the diffcrcncc and cumulative dilfcrencc arc also displayed graphically in figs. 5 and 6. Each figure also shows certain specific calendar dates which arc important in subsequent discussion of the masons for the abnormal bond pcrforni~ncc.

As fig. 6 shows, thcrc seems to bc upward drift in the cumulative diffcrcnce, which is consistent with the positive abnormal returns found for the post- petition period. Iiowcvcr, the upward drift appears to take place in only one time period, from 1940 through 1942. While the lcvcl of the cumulative dillcrcncc is relatively constant and close to zero in the 1936-1939 period, its lcvcl rises from 0.12 in January of 1940 to 1.21 in Dcccmbcr of 1942. The cumulative diffcrcnce in the 1943-1955 period does not appear to depart markedly from its level at the end of 1942.

Since increments in the level of the cumulative diffcrcncc are stochastic, the lcvcl would bc expected to show some movcmcnt, upward or downward, cvcn when the cxpcctcd value of the increment (Rb- R,) is equal to zero at each point in time. If the variance of the incrcmcnts were sulliciently high, results which were similar to those for the 1940-1942 period might be obtained even where no abnormal performance had taken place. Conversely, results like those for the 1936-1939 and 1943-1955 periods might bc obtained when the expected value of the increments was in fact significantly different from zero. Howcvcr, the mean diffcrcncc (Rb-R,) for the January 1940 - December 1942 period


Table 9

Values of (Ra- R,) and of the cumulative ditkrence.

Cumulative difference

January, 1940 -0.055 February 0.029 March 0.107 April - 0.005 MLly -0.050 June 0.036 July 0.011 August - 0.052 September 0.073 October 0.001 November -0.051 December 0.239

0.121 0.151 0.258 0.252 0.202 0.239 0.250 0.197 0.270 0.271 0.220 0.459

January. 19-J I February hl;lrch April May Junr July Augus1 Scptcnib+x Octolw Novcmtxr h!cen1txr

0.069 0.023 0.272 0.06 I

- 0.089 0.070

- 0.029 0.035

- 0.000 0.093

-0.034 - 0.035

0.528 0.551 0.823 0.884 0.800 0.x64 o.x3s 0.871 0.810 0.903 0.X69 0.x34

Jwuary. 1942 0.0x4 0.9IK i+bruary 0.08 I 0.999 March 0.236 I .23 April 0.020 1.25 M;1y - 0.054 1.20 June - 0.0’6 1.17 July -0.041 1.13 August -0.042 1.09 Scptcmbcr 0.076 1.17 Octotw -0.01 I 1.15 Novcmbcr -0.016 I.11 Dcccmtxr 0.097 1.21

January. 1943 February Mrtrch

-0.001 0.012 0.065

1.21 1.22 1.28

266 J-B. Warner, Bankrupfcy and the pricing of risky debt

was 2.79 percent per month, with a t-statistic of 1.95. Bond performance was apparently abnormally high for that period. For the December 1935 - December 1939 period the mean monthly difference is 0.36 percent, with a f-statistic of 0.404. For the January 1943 -November 1955 period the monthly difference

Fig. 5. Dillcrence between returns on bond portfolio and risk-adjusted stock calendar time.

portfolio -

Fig. 6. Cumulative dilTerence at the end of each month between returns on bond portfolio and risk-adjusted stock portfolio.

has a mean of 0.0016, with a t-statistic of 0.23. The mean difference for the combined 1936-1939 and 1943-1955 periods is 0.0021, with a f-statistic of 0.38.

Since returns on the sample bonds in the 1936-1939 and 1943-1955 periods

J.B. Warner, Bankruptcy and the pricing of rtiky debt 267

did not differ systematically from returns on other securities with the same level of risk, for those periods it is not possible to reject the joint hypothesis that the capital market understood the implications of deviations from tbe absolute priority rule and reflected that understanding in setting expected returns according to the Black model. The earlier finding that returns in the post-petition period were abnormal appears to be explained by the abnormally large realizations which took place during the 1940-1942 period. Possible reasons for the unusual performance of the sample bonds in that period are now explored.

6. J-Estorical background of the railroad reorganizations

During the time interval of high bond returns, important legal principles were being established in the field of railroad reorganization. Since the questions at issue involved the treatment of claimholders, the abnormality of realized returns on the railroad bonds might well be related to those proceedings in which the principles were established.

When Section 77 of the Bankruptcy Act was passed by Congress in 1933, it was not known how the courts and the Interstate Commerce Commission would interpret the rights of claimholders under the new law. One reason was that the ICC had never before been given a large role in bankruptcies. Under Section 77, the Commission was given vast powers in formulating reorganization plans. In fact, Section 77(d) of the Bankruptcy Act provided that no plan of reorganization could be given court approval unless the plan shall first have been approved by the Commission and certified to the court.

ICC approval of rcorgnnization plans first took place in the 1938-1939 period, when over a dozen plans received approval. The plans had two important features. First, all of them made substantial simplifications in the respective railroad’s capital structure. A major dcvicc used to accomplish the simplifications was the cxchangc of general system securities for the claims of bondholders who held specific liens against particular divisions or subsidiaries of a railroad. Second, the plans generally excluded common and preferred share- holders.

Whether the reorganization plans could evenlualiy be implemented depended on the resolution of two important legal questions. The first was whether the substitution of blanket mortgages for divisional mortgages was permissible. The second was whether railroad valuations by the ICC, upon which the ex- clusion of common and preferred stockholders had been based, were legally binding or merely advisory.

In several cases in the early 1940’s, the United States Supreme Court ruled on these matters. In Consolidated Rock Products v. DuBois, decided in March of 1941, and in Group of Institutional Investors v. Chicago, Milwaukee, St. Paul and Pacific railroad, decided in March of 1943, the court generally upheld the

268 33. Wurner, Bankruptcy and the pricing of k&y debt

simplification of capital structures by substitution of blanket securities for those of divisional lienholders.” In Ecker v. Western Pacific Railroad, decided in March of 1943, the high court held that the ICC had the right to make legally binding valuations.” _

6.1. Possible implications of the Supreme Court decisions

There is reason to believe that the announcement of the Supreme Court

“Consolidated Rock Products v. DuBois (312. U.S. 510 (1941)) and Group of Institutional Investors v. Chicago, Milwaukee, St. Paul and Pacific Railroad (318, U.S. 523 (1943)). The DuBois case was actually a non-railroad matter in which the ICC had no direct jurisdiction. However, there is evidence that the Commission had an interest in the outcome of the case. For example. the 1940 and 1941 Ar~n~cof Reports of the Commission (pp. 84 and 144, respectively) give the case considerable attention.

The DuBois case involved a company where, under the reorganization plan, various debtor subsidiaries were to be merged into a reorganized company and one bond issue substituted for separate bond issues of the subsidiary companies. In June of 1940. a Circuit Court of Appeal held that the plan of reorganisation was per se unacceptable because it substituted for several bond issues, scpamtcly sccurcd, new securities constituting an interest in all of the properties. Because of the importance of the cast in the tield of railroad reorganization, the ICC urged the Supreme Court to hear the case.

In hlarch of 1941, the Court rendered its decision. It held that: *. . . the substitution of a simple. conservative capital structure for a highly complicated one may bc a primary require- mcnt of any reorganization plan. There is no ncccssity to construct the new capital structure on the frnmcwork of the old.’

The hlilwaukce cast involved a rclatcd issue. The rcorganizrltion plan for that railroad had been approved by the ICC in February of 1940 and given District Court approval in &to- bcr of I%lO. In Dcccmbcr of 1941. the Court of Anneals rcicctcd the nlan. In April of 1942 the Supreme Court agreed to rule, and in March of ii43 it hcld that: ‘... . in rco&nization pro- cccdings the Commission need not make a precise finding as to the value of the company’s properties or the cxtcnt of the dcficicncy in order to climinatc the old stockholders. Neither is it ncccssary to make a dollar valuation of each old and new security in order to give fully compensatory trcalmcnt to senior claimants. (See A~~trucu of Supreme Cuurf Decisions Itrtcrprc*tirrg Ihe Inlcwltrle Cbtttnrcrce Act.)

Whcrcas the DulIois case had validated the very exchange of secured divisional liens for other system securities, the Milwaukee ruling made the exchange somewhat easier to eflcct. The fcxt or the Milwaukee decision makes rererencc to Consolidated Rock Products v. DuBois. and in no way changed the principles which had been cstablishcd in that case.

“Eckcr v. Wrstern Pacific Railroad (31s. U.S. 418 (1943)). This and the Milwaukee case were decided by the Suprcmc Court on March IS, 1943. The original reorganization plan for Western Pacific was certilicd by the ICC in Septcmbcr of 1939 and given court approval in August of 1940. In Novcmbcr or 1941 the Circuit Court of Appeals for the 9:h District rcvcrsed the decision. The Circuit Court held that the valuation made was improper because it did not allow the District Court 10 exercise its indcpcndent judgcment.

In March of 1942, the ICC filed a petition for a writ of certiorari. It was granted and in April of I942 the Supreme Court agreed to hear the cast. The court did so because the petition ‘asked adjudication of questions that wcrc important in the field of railroad reorganization. They involve the rcspcctive function of Commission and Court.’ (See the text of the decision and Tr&‘c World, March 20. 1943, p. 633.) In its 1943 decision, the Supreme Court held that: ‘the dctcrmination of value and whrthcr the plan is compatible with the public interest is for the Commission, and if its dctcrminations arc supported by evidence and are in accordance with legal standards, they are not subject to reexamination by the Court.‘ (Also scc Absfrucls

of Supreme Court Decisions Interpreting the Interstate Commerce Act. pp. 261-270.)


decisions might represent unexpected good news and might therefore be associated with large positive returns on the sample bonds if the outcomes had not been previously known with complete certainty. In the DuBois and Milwaukee cases, the court validated the type of capital structure simplifications which claimholders and the ICC had approved as part of the railroad reorganizations. Had the simplifications not been validated and had the rulings been in the opposite direction, additional resource costs would have to have been borne by the railroad firms, and hence their claimholders. At the minimum, there would have been costs associated with renegotiating the terms of reorganization. Moreover, a ruling forbidding such capital structure simplifications would have necessitated new capital structures which were exceedingly complex and which differed greatly from those which had been approved, and may have worsened the position of the holders of the sample bonds.

In figs. 5 and 6, it appears that a large portion of the abnormal bond returns were in the six month period prior to and including the month of the DuBois decision by the Supreme Court. From October of 1940 through March of 1941, the month of the decision, the value of the cumulative difference increases from 0.27 to 0.82. The largest positive value of (Rb-Rc) for any month from 1935 to 1955 is 0.27, which also occurs in the month of the decision. The next highest value of (Rb-R,) is 0.24, occurring in both December of 1940 and March of 1942. The first date follows by one month the ICC’s entering the case as a ‘friend of the court ,” perhaps altering the probability that the court would uphold the validity of the reorganization plans which the ICC had itself approved.

There was no abnormal bond performance in March of 1943, when the Milwaukee cast was dccidcd. The dilfcrcncc between the returns on the bond portfolio and the risk-adjusted portfolio is 0.065 for that month, less than one standard deviation from its mean for the 1935-1955 period. However, it should be noted that the actual returns on the two portfolios for that month (rather than the difference between returns) arc both very high. In the case of the bond portfolio, the return is 0.209, while in the cast of the control portfolio it is 0.144, compared to a return on the market index of 0.048. Both portfolio returns are about 2 standard deviations from their respective means for the 1935-1955 period. This suggests that the Milwaukee decision may have had an impact on all the railroads, not merely the bankrupt ones. The results are in contrast to those in the DuBois decision, in which month only the sample bonds had abnormal returns.

33Even though it was a non-railroad case, Supreme Court briefs were still filed by the Solicitor General on behalf of the ICC in the DuBois case, in October of 1940 and February of 1941. The contention of the ICC in those briefs was that ‘reorganization in some types of cases might be impossible’ if the elimination of divisional mortgages was disallowed. Moreover, the Commission argued that: ‘any plan attempting to preserve separate liens would necessitate so complicated a capital structure that it would not be feasible.’ See U.S. Supreme Court Briefs und Records (312, U.S. SlO), p. 14.


6.2. Additional evidence: Wealth transfers

The Western Pacific case, which was decided at the same time as the Mil- waukee case in March of 1943, could also have had implications for the behavior of the sample bond returns. The Western Pacific decision validated the valuation procedures which had been used by the ICC to exclude common and preferred StockhoIders. If the vahdation was unexpected, abnormal bond returns might reflect an unanticipated wealth transfer from stockholders to bondholders. Given that common and preferred securities of the sample railroads typicalIy sold at positive prices in the initial stages of bankruptcy, the argument that the wealth transfer was unanticipated is not without justification.

However, for the sample firms, the average debt/equity ratio, as measured by the ratio of the market value of the debt of the firm to the value of the equity (including preferred stock) at the end of month ‘0’ was approximately 20. The residual claims thus constituted a very small fraction, less than 5 percent of the market value of the firms. It is unlikely, therefore, that a complete transfer of wealth from the stockholders to the bondholders could fully explain abnormal returns of the magnitude observed.24

6.3. Additional evidence: Bankruptcy costs

The abnormal returns might also have resulted from adjustment to other types of information implicit in the decisions we discussed. The high court’s decisions in the DuBois, the Milwaukee, and the Western Pacific cases resolved a number of issues of long standing. The decisions upheld the major provisions of a number of reorganization plans, without the need to remand them to claimholders for major modification. When the Milwaukee and Western Pacific decisions were announced, in March of 1943:

At the Commission’s Bureau of Finance, it was indicated that the Supreme Court’s decisions . . . would have the effect of enabling the Commission and the federal district courts of jurisdiction to expedite action on railroad reorganization cases.2s

“It is always possible that the abnormal returns could have resulted if the sample bonds had received a wealth transfer from some claimholders. other than stockholders, whose securities are not included in the sample. However, the results are not simply the result of transfers within the sample of 73 bonds, since returns tend to be uniformly positive and abnormal across the entire sample in months such as March of 1941.

.

If World War II affected the bankrunt and non-bankruot railroads differently. this could also account for the abnormality of our performance measure. Inspection of monthly and annual industry data (income statements, balance sheets, traffic figures) suggests no systematic differences between railroad firms in the bankrupt and non-bankrupt categories.

a5Trufic World, March 20, 1943, p. 634,

J.B. Warner, Bankruprcy and the pricing o/risky debt 271

Within four years of that date, 10 of the sample railroads completed their reorganizations. It is unlikely that they would have been able to do so had the high court ruled in a manner which required extensive renegotiation and re- formulation of the terms of each railroad reorganization.

The court decisions, and the ICC’s support for the existing plans in its Supreme Court petitions, may have conveyed new information that the length of the railroad bankruptcies would be shorter than the market had anticipated. To the extent that the bankruptcy process was costly to the railroad firms, such information would have lowered the market’s assessment of the expected cost of bankruptcy, and resulted in an increase in the value of the firm’s securities.26

However, the contention that abnormal returns on the sample bonds might be related to changes in the market’s anticipation of bankruptcy costs does not appear to be strongly supported by the data. Warner (1977) has examined direct bankruptcy costs for a subsample of I1 of the 20 railroad firms. His data, while dealing only with the legal costs of railroad bankruptcy, show that actual bankruptcy costs turned out to be an average of 5 percent of the market value of the firm at the time of bankruptcy. Even if the market had originally expected the figure to be 10 percent, and if its estimate of the expected costs had been halved as a result of the court decisions or other events during the period in question, that would account for only a 5 percent increase in the value of the firm.

Since the bankruptcy costs, at lcast those Warner measured, turned out to be so small, an enormous shift in expectations, well in excess of the postulated 50 percent, would have been required in order for large abnormal returns to be observed on the sample bonds. It is possible that the bonds might represent claims so highly levered that they increased in value by a factor disporportionatc to the firm’s other claims when expectations changed; but it dots not seem likely that the change in the estimated costs could fully account for abnormal returns on the bonds of the magnitude observed.

4.4. Sotne contrary evidence

It is not clear whether the observed price changes during the months around the DuBois and Milwaukee decisions represented adjustment to new information about the prospects for the sample bonds, or a lagged adjustment to information which was available but which the market failed to take into account prior to the decisions. Two pieces of evidence which tend to support the view that price adjustment took place with a lag during this period relate to the history of the two cases in the lower courts.

‘“Such information might have been conveyed when the ICC petitioned the Supreme Court to hear the Western Pacific case. In the month in which the petition was filed, March of 1942, the sample bonds had an abnormal return of 0.24.


In June of 1940, prior to the Supreme Court’s hearing of the case, a Circuit Court of Appeals had ruled in the DuBois case. It held that the swap of general system securities for existing divisional obligations was not permissible in reorganization. There was no abnormal return on either the bond or the control portfolio in that month. It is not readily apparent why the bonds did not fall in price in response to an event which, given our scenario, should have been regarded as unfavorable. Similarly, in the Milwaukee case the Circuit Court of Appeals rejected a reorganization plan for a related reason, in December of 1941, but no negative bond returns occurred at that time. Since the progress of the cases was a matter of public record, it is difficult, in an efficient markets context, to explain why some price adjustment did not take place as the cases progressed through the lower courts.

7. Conclusions

Conditional on bankruptcy, returns on the sample bonds were abnormally high. The abnormality of returns appears to be due to large realizations occurring in the 1940-1942 period. Examination of the background of the railroad reorganizations and of the legal environment in that period indicate considerable correspondence between the sample bond returns and the cases whose resolution might reasonably have been cxpccted to have an impact on the sample bonds.

High bond returns were observed in months surrounding important develop- ments in the cases discussed. The returns appear to be related to the capital structure simplilications approved in the DuBois cast. The returns do not appear to be closely related to certain wealth transfers which the Supreme Court’s decisions validated, or to changes in the market’s anticipation of the length and cost of the railroad bankruptcies.

It is not clear, howcvcr, why upward price adjustments did not take place at an carlicr point in the railroad reorganizations. Morcovcr, certain lower court decisions should have had a ncgativc impact on sample bond prices, yet none was found. The facts do not constitute a prepondcrancc of cvidcnce in support of the view that the sample securities were properly priced during the time of the decisions. While the market appears to have been characterized by an absence of gross inefficiencies in the 1935-1939 and 1943-1955 periods, ex ante profit opportunities may well have been available to investors who bought the sample bonds in the early 1940’s. With the exception of that period, though, the evidence does not allow us to reject the view that the capital market was aware of the possibility of deviations from the absolute priority rule, and reflected that understanding in setting prices on risky debt claims.

J.B. Warner, Bankruprcy and rhc pricing o/risky debt 273

Appendix

Table A.1

Firms and securities in the sample.

Period in No. of monthly bankruptcy returns

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

Central of Georgia Railway Company Refunding and General Mortgage 5.5’s 1959 Refunding and General Mortgage 5’s 1959 Chattanooga Division 4’s 1951 Mobile Division S’s 1946

6/40-6148 246 246

E

Central Railroad of h'ew Jersey 1 o/39-9/49 5’s 1987 285 4’s 1987 255

Chicago, Itrdionapolis artd Loctisrille Refunding 6’s 1947 Refunding 5’s 1947 Series C Refunding 4’s 1947 Series A First and Gcncral 5’s 1966 Series I3 First and Gcncral 6’s 1966

12/33-3/46 243 243 243 243 243

Chicago. Milwottkcc attd St. P art1 6/35-l I/45 Gcncral Gold 4’s 1989 239 Scrics C 4.5’s I989 239 Scrics A 5’s 1975 203 5’s 2wo 203

Chicaflo otrd N*rlhwerIrrn 3.5’s 1987 4’s 1987

6135-6144

I5 Year Sccurcd 6.5’s 1936 First and Refunding 5’s 2037

Chicogo, Rock I.~lmd and Atcijic* General Mortgage 4’s 1988 First and Rcfuncling Gold 4’s 1934 Sccurctl Gold 4.5’s 1952 Choctaw. Oklahoma and Gulf 5’s 1952 Rock Island, Arkansas and Louisiana 4.5’s 1931 St. Paul and Kansas City Short Lint 4.5’5 1941

222 222 222 222

6/33-12147 264 264 240 264 264 264

Denccr ontl Rio Grctndc Western First Consolidated 4’s I936 First Consolidntrd 4.5’s 1936 Gcncral 5’s 1955 Refunding and Improvement 5’s 1978 First Trust 4’s 1939 First Consolidated 4’s 1949

1 o/35-3/47

Duluth, SONIII Shore and Atlutrtic 5’s 1937

Erie Railrood Prior Lien 4’s 1996 General 4’s 1996

I/37-10/49

1/38-l l/41

255 255 255 219 255 255

286

191 191


Table A.1 (continued)

(10)

(11)

Florida East Coasr Railway Series A First and Refunding 5’s 1974

Minneapolis, St. Paul and Sault Ste Marie 4’s 1938 5’s 1938 6’s 1946

g/31-11/52

l/3&9/44

(12) Missouri Pacific Railroad 3/33-l l/55 Series A First and Refunding 5’s 1965 General 4’s 1975 General J’s 1975 First and Refunding 5’s 1977 First and Refunding 5’s 1978 International Great Northern 6’s 1952 International Great Northern 5’s 1956 International Great Northern Series C 5’s 1956

(13) New York, New Haven and Hartford 4’s 1947 3.5’s 1947 3.5’s 1954 4’s 1955 4’s 1956 3.5’s 1956 6’~ 1948

10/35-B/47

(14) New York. Susqrrchanno and Western First Refunding 5’s 1937 4.5’s 1937

6/37-12152

General 5’s 1940

(15) R~trlmd Roilrood First 4.5’s 1941 Ogdcnsburg and Lake Champlain 4’s 1948 Rutland Canadian 4’s 1949

5/3R-5149

(16) St. Louis Son Frmrcisco Ruilwoy Series A 4’s 1950 Prior Lien 5’s 1950 Kansas City Port Scott and Memphis

Scabocvd Airline Rrrilwuys Conqxrny First 4‘s 1950 5’s 1949

5/33-l 2/46

(17)

Ug)

(19)

(20)

12/30-6/46

Refunding Gold 4’s 1959 First 6’s I945

Wobosh Roilrood First Gold 5’s 1939 Second Gold 5’s 1939 Refunding 5.5’s 1975 Refunding and General 5’s 1976 Refunding and General 4.5’s 1978

Wcsrern Pacific Series A 5’s 1946

12/31-l/42

8135-12144

Wisconsin Central Roilway General 4’s 1946 First 4’s 1936

12/32-4]54

323

225 225 225

359 359 359 335 311 329 329 329

260 260 260 260 260 260 260

324 324 324

281 281 ‘281

252 252 252

246 216 246 246

193 193 193 157 157

228

340 340

J.B. Warner, Bankruptcy and the pricing of risky debt

Table A.2

The control sample of common stocks.

275

(1) (2) (3) (4) (5) (6)

:;; (9)

(10) (11) 02) (13) 04) (15) (16) (17) (18) (19)

g; (22) (23) (24) (25)

Atchison, Topeka and Santa Fe Atlantic Coast Line Baltimore and Ohio Bangor and Aroostook Canadian Pacific Chesapeake and Ohio Delaware, Lackawanna and Western Gulf, Mobile and Ohio Green Bay and Western Hudson and Manhattan Kansas City Southern Lehigh Valley Louisville and Nashville Missouri/Texas/Kansas Railroad New York Central Norfolk and Western Northern Pacific Penn Central Peoria and Eastern Pittsburgh and West Virginia Reading Company Southern Pacific Southern Railway Texas and Pacific Union Pacific

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