Downside Stress Test For Credit Funds
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I am a second-year master's student in finance at a US university on OPT, and I want a distressed debt interview that really pressures my downside logic. Can you run a realistic session for a credit fund role? I want the questions to focus on recovery analysis, default scenarios, and spotting mispriced downside protection.
Absolutely. I will keep it in a distressed investing format and push on how you think about losses, not just upside. First question: imagine a company has a term loan trading at 68 and unsecured notes at 31. The business is under pressure from rising rates and soft demand, but it still has enough liquidity for 12 months. Walk me through how you would frame the downside case, including likely default timing, recovery paths, and what instrument looks mispriced if you believe the credit worsens.
I would start by separating liquidity stress from solvency stress. With 12 months of liquidity, near-term default may not be immediate, so I would focus on the next two to four quarters of EBITDA erosion, covenant pressure, and refinancing risk. I would build a downside case where margins compress, EBITDA falls, and the company burns cash faster than expected. Then I would look at the capital structure, likely collateral coverage, and enterprise value in a stressed scenario to estimate recoveries. If the term loan has strong first-lien collateral and the unsecured notes are already pricing in very low recovery, the unsecured may be more fairly priced than the loan if the loan is trading too high relative to expected recovery.
Good start, but I want more precision. Suppose the company has 400 million of first-lien debt, 250 million of second-lien debt, and 300 million of unsecured notes. In your downside case, you value the business at 600 million at the point of restructuring. Ignore fees for now. How do you think about recovery by class, and which security would you target if you were looking for mispriced downside protection? Then tell me what could make your answer wrong.
At 600 million of enterprise value, the first-lien lenders get paid first. They have 400 million outstanding, so they recover in full and there is 200 million left for second lien. The second lien has 250 million outstanding, so it would recover 200 million on a pro rata basis, or 80 percent, and unsecured would get nothing. If I were looking for mispriced downside protection, I would focus on whether the first-lien loan is trading too close to par, because it still looks protected even in a stressed outcome. But if the first lien is already around the mid-70s, that may be expensive relative to its high recovery. The answer could be wrong if the collateral is overstated, if there are superpriority claims, if the restructuring value is lower than 600 million, or if there are hidden structural subordination issues.
Better. Now I want you to pressure-test your own assumptions. Let us say the first-lien loan is trading at 84, the second lien at 52, and the unsecured at 18. Management claims liquidity is fine, but a major customer represents 22 percent of revenue and just cut orders. In that setup, what trade is most attractive from a downside perspective, and what is the simplest thesis memo you would write in an interview to defend it?
From a downside perspective, the second lien looks most interesting to me. It is still priced as though there is meaningful recovery, but it sits behind the full first-lien stack and is vulnerable if the customer loss accelerates default or reduces enterprise value. The first lien at 84 may already reflect strong expected recovery, while the unsecured at 18 could also be cheap, but it may simply be an option on a much deeper restructuring. My simple thesis memo would say: the company faces a meaningful revenue shock from a concentrated customer loss, liquidity may be adequate in the short term but the capital structure leaves limited room for error, and the second lien offers the best risk reward because it is pricing in a recovery that may not exist if enterprise value falls below the first-lien claim. The key downside catalyst is continued order cuts leading to cash burn, covenant pressure, and a lower recovery base.
That is the right general direction. Final pressure test: if I challenge you and say the second lien is actually not attractive because the first lien can amend and extend, push maturities out, and priming risk is low, how do you respond without sounding rigid? Give me a concise interview answer that shows judgment, not stubbornness, and then I will give you a feedback report.
I would respond that I am not anchored to the second lien if the amend and extend path meaningfully reduces near-term default risk and preserves value. In that case, I would revisit where the true mispricing is by comparing market price to expected recovery across scenarios, including a delayed restructuring. If priming risk is low and liquidity is extended, the first lien may still be the cleaner downside trade because it has the highest claim and the market may be overpaying for safety in a relatively resilient structure. My process is to start with the capital stack, test the default timeline, and then choose the security whose price is least justified by its stressed recovery, not just the one that looks weakest on the surface.