What is Distressed Debt

Debt of a company undergoing financial distress

What is distressed debt?

Distressed debt refers to the securities of a central bank or company which has either defaulted, is under bankruptcy protection or is under distress and moving towards the aforementioned situations in the near future. It includes all credit instruments that are trading at a significant discount and have a spread substantially wider that the industry average. Distressed debt is a part of the leveraged and high-yield loan market. They are below investment grade debt. The most common distressed debt securities are bank debt, bonds, trade claims and common and preferred shares.

How does distressed debt arise?

So circling back to our question. What is distressed debt? Distressed debt is not issued deliberately by an institution – they are only issued when the institution is in a situation of financial distress due to the market economy/industry wide trends, internal mismanagement or both. When a company is in financial distress, the original holders of the issued securities sell them to new buyers at a significantly discounted price. These new buyers hold the securities while the institution restructures and sell them after their value appreciates.

When are securities classified as distressed?

The securities of an institution are classified as distressed when the issuing institution cannot meet a large number of its financial obligations. Unlike junk bonds which have a credit rating of BBB (or lower), distressed securities have credit rating of CCC or lower. Furthermore, fixed income securities having a yield to maturity which is 1000 basis points greater than the risk-free rate of return are classified as distressed debt (Note: a related category, stressed debt, has a yield to maturity which is 600-800 basis points greater than the risk-free rate of return).

Rate of return

Distressed debt is sold for a very small fraction of its par value and offers a rate of return 1000 basis points higher than the risk-free rate of return. This is so because distressed debt is a high risk-high return debt security. Given the financially distressed position of the institution, the potential for default is high. However, financial distress is also a precursor to corporate restructuring. In the event that the corporate restructuring is successful, the institution is saved from bankruptcy and/or liquidation, allowing the debt security to be repaid in full.

Why invest in distressed debt? 

So what is distressed debt used for in terms of investments? Distressed debt firms become a major creditor in the distressed institution by purchasing a large number of the institution’s securities. They then have the leverage to prescribe the terms for the reorganization. If the reorganization is successful, they get a positive return on investment. Should the institution be liquidated, distressed debt firms may recover the entire amount invested because they are entitled to be repaid before equity holders.

Hedge funds, mutual funds, brokerage firms, specialized debt funds (like Collateralized Loan Obligations) and private equity firms are the dominant players in this market. Thus, investors with a high appetite for risk should invest in distressed securities. However, it should be noted that distressed stocks are riskier than distressed senior debt instruments.

Tips for investing in distressed debt

As an asset manager, or as someone hiring an asset manager, you should have/look out for the following qualities while investing in distressed debt:

  1. Complete understanding of bankruptcies, restructuring and reorganization.
  2. credit research platform consisting of experienced and well informed analysts.
  3. Knowledge regarding every segment of the capital structure of the issuing company. This consists of understanding the issuer’s repayment priorities, interdependent obligations, collateral offered and covenants.
  4. Ability to assess and ascertain the reason behind the institution’s distress and advise about downside risks and upside potential of investments accordingly.
  5. Liquidity and flexibility to exploit investment opportunities as an when they arise

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