Distressed DebtExplained, Advantages & Disadvantages, and Examples

Written By:
Lisa Borga

Distressed debt refers to financial instruments that are issued by businesses that are in bankruptcy or are at significant risk of going into bankruptcy.

Distressed debt is generally traded at a large discount as compared to its par value.

The reason for the steep discount is the high risk of these investments becoming worthless.

Distressed debt is taxed as being below investment grade by credit rating agencies.

Credit rating agencies give these ratings to show the risk that investors can expect when purchasing these bonds or securities.

Since distressed debt is rated as below investment grade, there is a large amount of risk involved in buying or selling these securities.

These securities are generally purchased by large institutional investors who expect to achieve a large return if the company recovers.

Characteristics of Distressed Debt

1. The companies that issue these securities are often in bankruptcy or about to enter the bankruptcy process.
2. Distressed debt is issued at a steep discount compared to its par value.
3. These securities are rated as being below investment grade by credit rating agencies.
4. Some large institutional investors will invest in these securities because it gives them the opportunity to make a large profit if the company recovers. Or, if the company goes bankrupt, they hope to obtain control of the company.

Understanding Distressed Debt

Distressed debt is issued by troubled companies at a steep discount.

It is typically purchased by large institutional investors that look for companies in this position and choose to buy debt securities, such as bonds from them, rather than stocks.

Investors such as these are also sometimes called vulture funds and believe that if the company manages to recover, it will make a significant profit.

Yet, if the company fails to recover and enters bankruptcy, they will still be paid since debt security holders are paid before stockholders.

Reasons for Investing in Distressed Debt

Individual investors generally do not choose to invest in distressed debt due to the high amount of risk involved in these investments, along with the complexities of these investments.

However, if an investor is interested in investing in distressed debt, they can do so by investing in hedge funds or mutual funds that do invest in distressed debt.

There are several reasons for which investors choose to invest in distressed debt.

• Some investors will buy these securities because they can be purchased at a large discount, and they will earn a significant profit if the company manages to recover.
• Another reason investors choose to invest in distressed debt is to achieve ownership or control of the company if the company goes into bankruptcy by negotiating in court during the bankruptcy process.
• A different reason some investors choose to invest in these securities is to increase their position in the company so as to increase their influence during bankruptcy negotiations in order to try and maximize their returns.

Advantages and Disadvantages of Investing in Distressed Debt

Although investing in distressed debt does involve a lot of risks, there are advantages to these types of investments in addition to the disadvantages, and we will discuss both of these.

Advantages

• There is a significant potential for reward when purchasing distressed debt due to the fact it is heavily discounted from its par value.
• Due to the very high risk involved in these investments, there is a high potential for reward.
• Investors in this kind of debt can obtain ownership of the company through negotiation during court proceedings if the company goes bankrupt.

Disadvantages

• There is a lot of competition between firms which can cause problems in negotiations during the company’s bankruptcy.
• These types of investments are not good for individual investors since extensive research and analysis are necessary to effectively invest in distressed debt.
• Investing in distressed debts brings very unpredictable results, which makes these investments best for experienced investors that are familiar with diverse risk management techniques.
• Investing in distressed debt is extremely risky.

Key Takeaways

• Investors should make sure they are comfortable with the high level of risk this type of investment involves before investing.
• Investors should research the company that is issuing the distressed debt they are considering investing in before they invest.
• It is important to carefully analyze the risk involved in any investment in distressed debt.

Final Thoughts

Distressed debts come with a very high level of risk, but they are still a suitable choice for some investors.

Investors who are willing to accept a lot of risk in return for a chance for high profits may be willing to invest in distressed debt.

Some of these investors may also believe they can reduce their risk by researching and finding companies they believe have a reasonable chance of recovery.