Case 051Credit, distressed and capital structureCore

Mandor Hotels' three-year bond trades at 82 with a 9% coupon and its shares at Rs 40. With a 25% chance of default, which instrument gives the better risk-adjusted return, and why might a credit investor and an equity investor disagree?

KKRNew York · 2025

The situation

Mandor Hotels, a mid-sized hotel chain with too much debt after an expansion, has a bond maturing in three years with a 9% annual coupon. It trades at 82 per 100 of face value. The shares trade at Rs 40.

You see two outcomes. With a 25% chance Mandor defaults early, before paying any further coupon; bondholders recover 50 per 100 of face and the equity is wiped out. With a 75% chance it survives: the bond pays its three coupons and is repaid at 100, and the shares reach Rs 70. Ignore reinvestment of coupons and taxes.

Your task

Compare the expected return and the risk of the bond and the share, say which is the better risk-adjusted bet, and explain why a credit investor and an equity investor looking at the same company might choose differently.

Quick check

At your 25% default view, which has the higher expected return over three years?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Both earn about 9.5% a year in expectation, so the bond wins on risk: it loses 39% in default where the share loses everything. Expected return per unit of spread is about 0.77 for the bond against 0.41 for the share. The two investors disagree because the answer turns on the default chance: below 25% the share has the higher expected return, above it the bond does.

Step 1What does each instrument pay in each outcome?

Write the two outcomes as a small table before any averaging. The bond has a capped upside and a cushioned downside; the share has a large upside and no floor at all. Lending to a friend's restaurant is the everyday version: if it does well you get your money back with interest and nothing more; if it fails you might recover the kitchen equipment. Owning a share of the restaurant pays far more if it thrives and nothing if it shuts. For Mandor, Rs 100 in the bond becomes 154.9 or 61.0; Rs 100 in the share becomes 175 or zero.

Rs 100 in Mandor's bond becomes Rs 154.9 if the company survives and Rs 61.0 if it defaults, while Rs 100 in the share becomes Rs 175 or nothing; the expected values are almost equal but the bond loses far less in default.

Step 2How do you compare them on risk as well as return?

Take the expected gain and divide it by how widely the outcomes are spread. With two outcomes, the spread is the gap between them times the square root of 0.25 x 0.75. The bond's outcomes sit 94 points apart and the share's 175 points apart, so for the same 31% expected gain the bond carries a little over half the risk. That gives about 0.77 of return per unit of spread for the bond against 0.41 for the share, a rough Sharpe-style ratioExpected excess return divided by the standard deviation of outcomes; here used without a cash rate, only to compare two bets on the same company. that is enough to rank them.

The relationship

E[\text{bond}] = 0.75(127) + 0.25(50) = 107.75 \qquad E[\text{share}] = 0.75(70) + 0.25(0) = 52.5

127	100 of face plus three coupons of 9
50	recovery per 100 of face if Mandor defaults
70	share price if Mandor survives

What it says in wordsAgainst prices of 82 and 40, both expected values imply a gain of about 31% over three years.

Step 3Why would a credit investor and an equity investor disagree?

Because the whole answer rests on one number, the chance of default, and the two investors are paid to see it differently. At a default chance of 24.8% the two expected returns are equal; below it the share wins and above it the bond wins. An equity investor who thinks the risk is 15% sees the share returning 48.8% against 40.8% for the bond. A credit investor who thinks it is 35% sees the bond at 22.0% against 13.7% for the share. Notice that your 25% view sits almost exactly where the market's prices put the two in balance.

Expected three-year returns on Mandor's share and bond cross at a 24.8% chance of default: an investor who believes default is less likely prefers the share, and one who believes it is more likely prefers the bond.

Close with the difference the interviewer is really asking about. A credit investor's job is to be repaid; the question is what is lost if things go wrong and how much the recovery protects. An equity investor's job is to own the upside; the question is how large the good case is. Same company, same facts, different question, which is why the two desks often hold opposite views on a stressed name without either being wrong.

Where candidates lose it

Most candidates see the share rising 75% against the bond's 55% and call the share the better bet. That compares the good outcomes only. Weighted by probability the two are level, and the share's bad outcome is total loss.

The second miss is forgetting the recovery. Treating default as zero for the bond too makes the two instruments look alike and hides the one feature that makes credit different from equity: seniority means something is left when things go wrong.

What the interviewer asks next

Recovery in default falls from 50 to 30. At what default chance are the two now equal?
How would you build a capital structure trade, long the bond and short the share, and what does it earn in each outcome?
Mandor's coupons are paid until the year it defaults. How does that change the bond's expected return?

Asked at KKR, Distressed Debt, New York, 2025 (Wall Street Oasis): What is the difference between credit and equity investments?

Company names and figures are illustrative.