What Is Distressed Debt? An Investment Guide

·5 min read
Opportunity amid crisis
Opportunity amid crisis

Distressed debt is debt that belongs to companies or government entities that are struggling financially. These entities may be in bankruptcy or in danger of having to file bankruptcy because their financial obligations are too great. Distressed debts can create opportunities for investors who purchase them at a discount. Investors can profit if the company is able to turn itself around and emerge from bankruptcy or avoid it altogether. While distressed debt investing can offer the potential for higher rewards, it can also entail higher risk.

Consider talking to a financial advisor about the pros and cons of distressed debt investments and whether that makes sense for you.

What Is Distressed Debt?

When a company or government entity has debt that it’s in danger of defaulting on or has already defaulted on, it can become a distressed debt. Borrowers that owe distressed debts may have too many liabilities or not enough revenue to cover their obligations. They may turn to bankruptcy to restructure their debt and finances moving forward.

Distressed debts can include loans or lines of credit, bonds and common or preferred shares of stock. These debts are typically identifiable by their credit rating, such as those issued by Moody’s. A distressed debt generally has a credit rating of CCC or lower, putting them below the ranks of junk bonds.

What Is Distressed Debt Investing?

Distressed debt investing is a strategy that involves buying the debts of companies that are in financial trouble. The advantage in doing so is that distressed debt can often be purchased at a steep discount relative to its par or face value. Distressed debts are sold at a discount because the risk of the borrower defaulting on them or declaring bankruptcy is high.

Investors may turn to distressed debts hoping for one of three possible outcomes:

  • The company recovers financially, increasing the value of its debt and allowing investors to turn a profit by selling it on the open market.

  • The company does not recover or goes through a restructuring, which allows debt buyers to claim an ownership share.

  • The company files Chapter 11 bankruptcy and restructures, with distressed debt buyers receiving first priority for repayment.

The distressed debt market is typically the domain of institutional investors, including hedge funds, mutual funds, brokerage firms and private equity firms. Distressed debt investing can require large amounts of ready capital to buy up debts of struggling companies, even when that debt is discounted. Aside from that, investing in the debts of troubled companies can be risky.

If a hedge fund buys up distressed debts on the assumption that the company can get back on track financially, they have to be fairly certain that it can and will happen. Otherwise, the hedge fund is going to be stuck with distressed debt that may have little to no value. The upside, of course, is that distressed debts have the potential to yield higher returns for debt buyers if the company is able to pull through.

How Distressed Debt Investing Works

"Debt Help" sign
"Debt Help" sign

When a hedge fund or another institutional investor is interested in buying distressed debt, they can identify opportunities, based on their goals. For example, say a hedge fund is specifically interested in buying debt that could then be resold later. They may seek out companies that are struggling financially but are likely to turn that around and become profitable once again.

There are different ways hedge funds can purchase distressed debt. For instance, they can purchase distressed corporate or government bonds through the bond market. Hedge funds can also work out the purchase of distressed debt directly with the company.

By purchasing distressed debt, the buyer provides the company with cash. It’s then up to the company to make the most of these funds to become solvent once again. If the company is unable to do that, then the buyer has an opportunity to take control of it or be first in line for payment in a bankruptcy filing.

Distressed debt investing can be attractive because of the returns it may generate. A commonly used rule of thumb says that distressed debts can offer a rate of return that’s 1,000 basis points (10%) higher than the risk-free rate of return. Since the debt is purchased at a discount, that can amplify returns if the buyer’s hunch pays off.

Distressed Debt and the Individual Investor

The distressed debt market is not exclusive to institutional investors; individual investors can also buy in. For example, you could buy distressed bonds on the bond market the same way that a hedge fund or private equity firm might.

Individual investors can also invest in distressed debt through mutual funds or exchange-traded funds that include these securities. The advantage of buying distressed debt through a mutual fund or ETF is diversification. Instead of concentrating your money into a single distressed debt investment, you can spread it across multiple investments, based on the fund’s holdings.

Whether it makes sense for you to invest in distressed debt can depend largely on your risk tolerance. Investing through mutual funds can help to spread out risk but it’s important to understand the potential for losses with this type of strategy. Balancing out distressed debt investments with stocks, bonds and other securities can help you to keep risk in check.

The Bottom Line

Man in water surrounded by sharks
Man in water surrounded by sharks

Distressed debt can be problematic for companies or government entities. If a company isn’t able to move toward solvency, that could put them at increased risk of having to file for bankruptcy protection from creditors. For investors, on the other hand, distressed debt could yield solid returns. The key to avoiding losses is knowing how to identify distressed companies that have the potential to improve their financial situation.

Tips for Investing

  • If you have yet to find a financial advisor to help you sort through your options for investing in debt, there’s a resource that can make it easier. SmartAsset’s financial advisor matching tool helps investors to connect with professional advisors in their local area. Just answer a few simple questions to get your personalized advisor recommendations. If you’re ready, get started now.

  • Inflation can cause securities to depreciate. Use our free inflation calculator to gauge the buying power of your dollars over time.

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