Vose SoftwareModelChoice decision tree · Corporate finance
Distressed Debt Investment
Buy the senior secured debt, the unsecured debt, a credit default swap, or take no position?
From the model’s decision tree
Best first decision: Credit Default Swap ($5M Premium)
The expected value of each first option when every later decision is also made well (the tree rolled back).
| First decision | Expected value | |
|---|---|---|
| Buy Senior Secured ($50M at 60c) | $4,530,500 | |
| Buy Unsecured ($30M at 25c) | $3,787,500 | |
| Credit Default Swap ($5M Premium) | $23,325,000 | ✔ best |
| No Position | $0 |
| Measure | Value |
|---|---|
| Expected value of the best strategy | $23,325,000 |
| Chance of a loss on the best strategy | 45.0% |
| Best outcome on the best strategy | $75,000,000 |
| Worst outcome on the best strategy | −$5,000,000 |
S-curve (cumulative probability) of Credit Default Swap ($5M Premium) from the saved simulation.
The decision
A distressed debt fund is evaluating an investment in the bonds of a troubled national retailer facing declining sales, excessive leverage, and upcoming debt maturities. The company's capital structure includes senior secured notes and unsecured bonds, both trading at deep discounts.
Objective
Maximize expected profit. Key uncertainties include restructuring outcome (prepackaged, Chapter 11, or liquidation), recovery rates by seniority, resolution timeline, and whether to participate in DIP financing.
The options
- Option 1: Buy Senior Secured ($50M face at 60 cents)
Purchase $50M face value of senior secured bonds for $30M. First lien position provides priority in bankruptcy. Three restructuring scenarios: prepackaged bankruptcy (quick), Chapter 11 (uncertain), or liquidation. If Chapter 11, decide whether to provide DIP financing for better recovery.
- Option 2: Buy Unsecured ($30M face at 25 cents)
Purchase $30M face value of unsecured bonds for $7.5M. Lower cost but junior position means much lower recovery rates. Potential for equity conversion in a debt-to-equity swap could yield outsized returns.
- Option 3: Credit Default Swap ($5M Premium)
Buy CDS protection paying $5M premium. Pure bet on credit event. If the company defaults, payout depends on recovery rate auction. If it survives or restructures without triggering the CDS, the premium is lost.
- Option 4: No Position
Stay on the sidelines. No risk, no return.
The decision tree
The tree has 3 decisions, 14 chance events and 30 outcomes. The best path is open: at every decision the best choice is marked, and the expected value beside each branch counts every cash flow from the start. Open any other branch to see what follows it.
DecisionChance event+$ cash flow on the branch
Buy Senior Secured ($50M at 60c) −$30,000,000expected $4,530,500
Chance: Restructuring Outcome (Senior)30% Prepackaged Bankruptcyexpected $11,385,000
Chance: Recovery Rate (Prepack Senior)35% Full Recovery 100cexpected $17,500,000
Chance: Resolution Timeline- 50% Quick (6 months) +$50,000,000payoff $20,000,000
- 50% Delayed (18 months) +$45,000,000payoff $15,000,000
40% High Recovery 85cexpected $10,025,000
Chance: Resolution Timeline- 45% Quick (6 months) +$42,500,000payoff $12,500,000
- 55% Delayed (18 months) +$38,000,000payoff $8,000,000
- 25% Moderate Recovery 70c +$35,000,000payoff $5,000,000
45% Chapter 11 Filingexpected $4,700,000
Decision: Chapter 11 - DIP Decision (Sr)Provide DIP Financing ($15M) −$15,000,000expected $3,500,000
Chance: DIP Financing Outcome (Senior)- 50% Successful Reorganization +$65,000,000payoff $20,000,000
- 30% Partial Recovery +$40,000,000payoff −$5,000,000
- 20% Converts to Ch7 +$20,000,000payoff −$25,000,000
Wait Through Processexpected $4,700,000 ✔ best
Chance: Ch11 Wait Outcome (Senior)- 40% Reorganization Plan Approved +$45,000,000payoff $15,000,000
- 35% Protracted Process +$32,000,000payoff $2,000,000
- 25% Converts to Liquidation +$22,000,000payoff −$8,000,000
25% Liquidationexpected −$4,000,000
Chance: Liquidation Recovery (Senior)- 40% Orderly Liquidation +$35,000,000payoff $5,000,000
- 60% Fire Sale +$20,000,000payoff −$10,000,000
Buy Unsecured ($30M at 25c) −$7,500,000expected $3,787,500
Chance: Restructuring Outcome (Unsecured)30% Prepackaged Bankruptcyexpected $4,050,000
Chance: Recovery Rate (Prepack Unsec)- 30% Equity Conversion 60c +$18,000,000payoff $10,500,000
- 40% Partial Recovery 40c +$12,000,000payoff $4,500,000
- 30% Minimal Recovery 15c +$4,500,000payoff −$3,000,000
45% Chapter 11 Filingexpected $9,300,000
Decision: Chapter 11 - DIP Decision (Unsec)Provide DIP Financing ($8M) −$8,000,000expected $9,300,000 ✔ best
Chance: DIP Financing Outcome (Unsec)- 40% Debt-to-Equity Swap +$45,000,000payoff $29,500,000
- 35% Partial Cash Recovery +$18,000,000payoff $2,500,000
- 25% Near Total Loss +$2,000,000payoff −$13,500,000
Wait Through Processexpected −$1,000,000
Chance: Ch11 Wait Outcome (Unsec)- 30% Favorable Plan +$15,000,000payoff $7,500,000
- 40% Cramdown +$5,000,000payoff −$2,500,000
- 30% Wiped Outpayoff −$7,500,000
25% Liquidationexpected −$6,450,000
Chance: Liquidation Recovery (Unsec)- 35% Some Recovery 10c +$3,000,000payoff −$4,500,000
- 65% Negligible Recoverypayoff −$7,500,000
Credit Default Swap ($5M Premium) −$5,000,000expected $23,325,000 ✔ best
Chance: Credit Event Outcome (CDS)55% Credit Event Triggersexpected $46,500,000
Chance: CDS Settlement Value- 40% Low Recovery = High Payout +$80,000,000payoff $75,000,000
- 35% Medium Recovery +$45,000,000payoff $40,000,000
- 25% High Recovery = Low Payout +$15,000,000payoff $10,000,000
- 30% Company Survivespayoff −$5,000,000
- 15% Restructuring (No Trigger)payoff −$5,000,000
- No Positionpayoff $0
Change the numbers. Open the workbook with ModelChoice, change a probability or a cost in the tree, and the best decision updates at once.
Key assumptions
| Assumption | Value | Notes |
|---|---|---|
| Senior Secured Face Value | $50,000,000 | First lien bonds |
| Senior Purchase Price | $30,000,000 | 60 cents on the dollar |
| Unsecured Face Value | $30,000,000 | Junior unsecured bonds |
| Unsecured Purchase Price | $7,500,000 | 25 cents on the dollar |
| CDS Premium | $5,000,000 | Annual premium for credit protection |
| Prepack Probability | 30% | Best outcome for all creditors |
| Chapter 11 Probability | 45% | Extended process, uncertain recovery |
| Liquidation Probability | 25% | Worst case, asset fire sale |
| Senior Recovery (Prepack) | 70-100 cents | Priority claim on assets |
| Unsecured Recovery (Prepack) | 15-60 cents | Junior claim, high variance |
| CDS Credit Event Prob | 55% | Based on restructuring likelihood |
The figures are illustrative: the companies and numbers are invented for teaching.
Try it in ModelChoice
- Strategy Table. Compare senior vs unsecured vs CDS approaches
- Sensitivity Analysis. How do recovery rates and restructuring probabilities affect returns?
- Risk Profile. Visualize downside exposure for each position type
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Further reading
Download the workbook and open it with ModelChoice. The free trial opens every example.
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An illustrative example: the figures are invented for teaching. Last updated 9 October 2026.