Distressed Debt

Distressed Debt refers to securities that have made a default, or under the process of bankruptcy, or facing situations that could lead to bankruptcy and are usually traded at large discounts in comparison to their par value. There is a great deal of risk involved in the purchase or sale of these securities as financial distress or bankruptcy may lead to these securities becoming worthless or zero.

The market for distressed debt funds is a high-yield and leveraged market. It is most often determined as a below-investment category due to its high-risk element. The most common types of such debt are bonds, trade claims, common and preferred shares, and bank debt. When a company is in distress, the original issuers of the security sell it to others at a steep discount.

• Distressed debt refers to bonds or loans issued by companies facing financial difficulties, often characterized by the risk of default or bankruptcy. These distressed securities are generally traded at significant discounts to their face value due to the higher perceived risk.
• Investing in distressed debt can yield higher returns than traditional investment-grade bonds. This is because distressed debt investors aim to capitalize on the potential recovery value of the troubled company's assets or the restructuring of its liabilities.
• Distressed debt investments carry a higher risk than investment-grade bonds due to underlying companies' financial challenges.

Distressed debt refers to the securities of a company or a government that has either defaulted on their loan, or is undergoing a bankruptcy protection. It is important to clarify that it is not issued by a particular entity.

The initial issuers of the security sell the security to another buyer at a significant discount to save themselves from facing serious losses by lending to a company that might file for bankruptcy.

These securities have a below-investment-grade rating. Investment-grade ratings are provided by credit risk agencies, which signify the risk associated with particular securities or bonds. And since these securities are considered to be of lower investment-grade rating, thus a high level of risk is associated with their buying and selling.

Investors buy or invest in these securities relying upon distressed debt analysis that if the company does not go into bankruptcy, they will realize a high return on their current purchase of securities at a significant discount. Mostly, large institutional investors invest in these kinds of securities like hedge funds, private equity funds, etc.

These securities are issued at a substantial discount to itstheir par value by companies that are facing financial difficulties. Large institutional investors identify these kinds of companies and deliberately purchase debt securities like bonds instead of stocks or shares.

These investors, also known as “vulture funds,” are of the view that if the company comes out of its financial difficulties, they will earn high profits. And if it does go into bankruptcy, they will still get their due payments as they are debt securities holders, hence will get priority over shareholders.

Let us understand the features of distressed debt funds through the explanation below.

• They belong to companies that are facing financial difficulties or are on the verge of being bankrupt.
• They are issued at high discounts from their par value or face value.
• Credit rating agency allots below investment grade rating to distressed debt securities.
• Large institutional investors invest in these debt instruments or bonds, either to reap a substantial profit if the company does not go into bankruptcy or else getting control of the business in case it does become bankrupt.

Let us understand the different types under distressed debt funds through the points below.

• Distressed debt investments where investors are buying debts at significant discounts and looking to earn substantial profit in case the table turns around.
• An investment where investors are looking to gain the control or ownership of the defaulted company through negotiation in courts if the company goes into bankruptcy.
• An active non-control strategy where these investors involve themselves in the restructuring process of the company so that they can negotiate and maximize and safeguard the interest of the class of securities held by them.

Since it is a high-risk investment that has probability stacked against the investor in most cases, individual investors stay wary of these investments in most cases. Let us understand who ends up buying such high-risk high-return instruments through the explanation below.

• It is very difficult for individual investors to go into distressed debt investment due to the high risk involved and several other complexities. But they can choose to do so by investing in hedge funds or mutual funds who are buying such debts.
• Therefore, investors with a large appetite for risk management can go into such debt securities investments. Private equity firms, hedge funds, mutual funds, specialized debt funds are the main investors in the market who go for distressed debt investment because they have access to high- risk management strategies which an individual investor might not have to.

Let us understand the concept of distressed debt analysis with the help of a couple of examples. These examples will give us a practical outlook and help us with an in-depth overview of the concept.

Example #1

In the late 1980s, Martin Whitman, an American investor, purchased distressed debt securities of an oil service firm that was facing financial difficulty, gained control of the company, and went into debt to equity deals with other creditors. The company came out of bankruptcy, and Whitman made a substantial profit.

In the mid-1990s, Franklin’s mutual funds purchased distressed debts from Canadian real estate Companies, who built Canary Wharf, London office complex. Franklin Investment reaped out a substantial profit when the holding company became bankrupt.

Example #2

In June 2023, the US distressed debts rose 300 percent in 12 months to a staggering $650 billion. Multiple pain points such as real estate issues in China, pension-blow up in the United Kingdom, and multiple major banks going under in the United States had seen shockwaves reach multiple sectors and economies.

A major cause of the steep incline of these types of debts is also linked to the multiple rate hikes by the federal reserve and central banks across the world. Lending and borrowing experienced a major shift in the 12 months between 2022 and 2023.

Moreover, since the world’s largest economy- the US, had also averted the first debt default in its history by a whisker, it became obvious that the economy of not just the US but also other related economies might be affected. As a result, distressed debts rose to a record high.

Let us learn about the importance of distressed debt analysis through the points below.

• Investors should consider their risk appetite and access to risk management strategies.
• Research and analysis of the company whose distressed fund investors are going to buy to know if the company would be able to come out of financial difficulty or not.
• Capability to realize benefit out of every investment opportunity which will come in the way while investing in distressed debt funds.
• Analysis of the risk involved with the investment in the troubled company.

Let us understand the advantages of distressed debt analysis through the points below.

• Buying debts or bonds at a high discount to its par value gives way for the high potential of reward.

• In case the company goes into bankruptcy, distressed debt investors can get ownership or control of the troubled company through negotiation.
• It is one of the high risks, thus high reward deals, as we all know, “higher the risks, higher the rewards.”

Despite the various advantages mentioned above, there are a few factors that prove to be a disadvantage for investors and lenders. These points are scrutinized and analyzed thoroughly before distressed debt funds invest in them. Let us understand the disadvantages through the discussion below.

• The distressed debt fund market is very unpredictable in nature; it needs an experienced investor with access to diverse risk management techniques to enter into this market.
• High competition between firms leads to difficulties in negotiation at the time of the bankruptcy of the company.
• A lot of research and analysis is required before investing in these kinds of funds; therefore, it is not optimal for an individual investor.
• The risk associated with this type of investment is enormously high.

This has been a guide to What is Distressed Debt. Here we explain its features, examples, types, advantages, and disadvantages. You can learn more about from the following articles –

• Debt Consolidation
• Recourse Debt
• Convertible Debt
• Sovereign Debt