Individuals and firms who are looking to grow capital through investing typically have a wide range of assets to choose from. The most common options by far are stocks, bonds, and cash investments (such as money market funds and certificates of deposit (CDs). Beyond these familiar choices lies another category of investments known as alternative investments. One intriguing option within this category is distressed debt, which can appeal to debt investors looking for unique investment opportunities.

If you’re unfamiliar with distressed debt investing or just want to learn more about it, this guide is for you. We’ll tell you everything you need to know including how it works, the potential risks and rewards, and how to get started as a distressed debt investor. 

What is Distressed Debt?

Distressed debt refers to debt securities of a company that is experiencing significant financial strain, or “distress.” These debt securities are usually on the brink of default or may already be in default.

Distressed debt investing involves buying such securities from existing lenders, often at a steep discount. This offers investment opportunities to turn in a good profit if the company that issued them manages to recover financially or restructure successfully.

When Do Securities Classify as Distressed?

A company’s debt may be classified as distressed if it’s rated CCC and below by any major credit rating agency. It is also classified as distressed when its yield to maturity exceeds the benchmark government securities’ yield by a substantial margin. In the context of distressed debt, the critical threshold often cited is a yield that is 1,000 basis points (or 10 percentage points) higher than comparable-maturity government bonds.

This substantial gap reflects the market’s assessment that the issuer is in financial jeopardy and that there’s a high chance that it won’t be able to meet its debt obligations. The larger the yield spread, the greater the distress and risk perceived by the market. 

How Does Distressed Debt Happen?

Many factors can impair a company’s financial health and lead to its debt securities being classified as “distressed”. These include:

• Economic downturns which can impact a company’s revenue and profit margins.
• Industry-specific challenges — like technological advancements, regulatory changes, and shifts in consumer preferences — which can disrupt a company’s operations and market position.
• Internal mismanagement which can lead to inefficient operations and financial instability in a company. 

Why Invest in Distressed Debt?

Investing in distressed debt offers several benefits. Here are the most notable ones.

High Returns Potential

The primary reward for an alternative investment like distressed debt investing is the potential for high returns. Typically in the distressed debt market, distressed securities are priced at a steep discount to their par value due to the high risk of default.

This discount provides an opportunity for substantial returns if the issuer recovers financially. The recovery can result from successful restructuring, a merger or acquisition, or an overall improvement in the industry or economy. Distressed debt investors stand to benefit from capital appreciation as the debt security’s value rebounds, alongside interest income, which can be more attractive than traditional interest rates.

Diversification

Distressed debt offers diversification benefits. This category of assets typically has a low correlation with traditional asset classes like stocks, bonds, and cash. It can offer a hedge against adverse movements in other areas of an investor’s portfolio.

Opportunity for Active Involvement 

Distressed debt also provides an opportunity for active involvement in the restructuring or the turnaround process of a company. This active involvement can lead to a more favorable resolution of the distressed situation, enhancing the potential for a successful investment.

Important note: If an investor believes that a distressed entity can weather the financial storm and eventually become profitable without restructuring or declaring bankruptcy, equity might be a better investment. However, if the investor thinks the company will have to restructure and/or file for bankruptcy, debt securities are the better choice due to the fact that they have a higher claim on the company’s assets in the event of liquidation, i.e. Chapter 7 bankruptcy.

Risks and Challenges of Distressed Debt Investing

Investing in distressed debt, while offering several potential benefits, also comes with a few risks.

No Guarantee of Return

Although debt securities generally have a higher claim than equity in a liquidation scenario, it’s still not guaranteed that investors will recover all due payments or even their initial investment. The distressed entity may have other obligations, such as tax liabilities, that supersede the debt securities in claim priority. These higher-priority claims could exhaust the funds available from liquidated assets, leaving little to nothing for distressed debt securities holders.

Lack of Information 

Investors may face challenges in obtaining transparent and reliable information about the distressed company’s financial situation. This can make it difficult to accurately gauge the true risk and value of the investment.

Who Typically Invests in Distressed Debt? 

Though individual investors can invest in distressed debt, the main players in this market are institutional investors such as hedge funds, mutual funds, and private equity firms. This class of investors is often more equipped to manage the complexities and uncertainties that characterize distressed debt markets. For example, they possess or have access to extensive research teams and financial analysts who are adept at evaluating and managing distressed assets. 

These investors also have substantial capital at their disposal, and can therefore make significant investments in distressed debt securities. This then allows them to have a voice and say in the distressed entity’s restructuring efforts or bankruptcy proceedings, which can be critical in shaping the outcome of their investments.

What’s more, the way they are structured means that they can handle higher levels of risk. Take a hedge fund, for example. Even if it invests a considerable amount in a company’s distressed debt, this investment usually represents only a small fraction of its total portfolio. That means low exposure and impact on investors if the distressed debt investment does not perform as expected.

How To Invest in Distressed Debt

If you’re ready to invest in distressed debt, here’s a practical step-by-step guide you can follow. 

• Identify targets: Start by identifying companies or entities in financial distress. Monitor credit ratings, track yield spreads, and stay informed about firms facing bankruptcy, restructuring, or severe financial challenges.
• Conduct due diligence: Once you’ve identified a target, conduct thorough due diligence. Examine its balance sheets, income statements, and cash flow statements. Understand why the company is exactly in financial distress. For example, is it because of internal mismanagement, industry-specific challenges, or broader economic factors like a recession? This insight is crucial for evaluating the likelihood of recovery and is a key aspect of distressed investing. 
• Assess the debt structure: Get a clear understanding of the legal structure of the debt including its seniority. In other words, analyze the debt structure to determine your position in the event of a default. This will help you determine if the investment is worth the risk. Consult with a legal expert if necessary.
• Determine the entry point: Decide the optimal time to invest, considering factors like current market conditions and the distressed securities’ pricing.
• Make the investment: Once satisfied with the risk-reward profile and the timing, go ahead and invest.
• Monitor the investment: After investing, continuously monitor the investment and the issuer’s performance. Be prepared to adjust your strategy in response to new developments or changes in the market.
• Plan an exit strategy: Have a clear exit strategy in place. This could be selling the investment after achieving a certain profit margin or in response to improved credit ratings or financial stability of the issuer. 

Wrapping Up: Understanding Distressed Debt Investing

Distressed debt offers a unique and potentially rewarding investment opportunity for those who are equipped to navigate its complexities. Like any other investment, however, there are no guarantees of positive returns. Success hinges not only on identifying the right opportunities but also on conducting thorough and effective due diligence.

CapLinked’s Virtual Data Rooms (VDRs) provide a secure, efficient platform for storing and managing the vast amounts of data and documentation necessary for comprehensive due diligence. Featuring a user-friendly interface and a comprehensive suite of premium features, CapLinked can help investors streamline their analysis of distressed debt investments, collaborate effectively, and ultimately make informed decisions.

Sign up for a free trial today. 

Sources

Capital.com: What is CCC Credit Rating?

Corporate Financial Institute: Par Value – Definition, Example, Importance

US Courts: Chapter 7 — Bankruptcy Basics

Forbes: How Diversification Works, and Why You Need It

Sean LaPointe is an expert freelance writer with experience in personal and business finance. He has written for several well-known brands and publications, including The Motley Fool and Angi/HomeAdvisor.