The credit-spread term-structure model
According to the credit-spread term-structure model, highly leveraged firms or firms with fast deteriorating credit fundamentals will experience an inverted credit curve. The bonds begin to trade on a price basis. If default is a very likely scenario, bonds of the same seniority trade with the same price, irrespective of their maturity and coupon. This has the effect of elevating short-maturity spreads and inverting the credit curve. Depending on the investment objective the following investment strategy should be pursued:
1. Uncertainty about medium-term prospects prevails and a further deterioration is most likely: shorter duration, long-dated paper will underperform.
2. Uncertainty about medium-term outlook is present but the price move in the bonds seems to be overdone (e.g. due to technical factors). A turnaround appears to be a likely scenario: buy the cheapest bonds (long-dated paper). If the situation stabilizes then this strategy will result in the highest capital gains.
3. Same scenario like Scenario 1 but the uncertainty about the short-term outlook of the company increases. Default is a distinct possibility. In this case investors should sell their short-dated paper first. Those bonds have the highest price and will underperform as all maturities will converge towards the estimated recovery value (prices of short-dated paper will collapse).