What is Distressed Debt?
Distressed debt refers to the securities of a government or company that has either defaulted, is under bankruptcy protection, or is in financial distress and moving toward 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 than the industry average.
Distressed debt is a part of the leveraged and high-yield loan market, and is rated 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 entity – it is only issued when the entity is in a situation of financial distress due to the market economy or 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 hope to hold the securities while the company restructures and then sell them after their value appreciates.
When are Securities Classified as Distressed?
The securities of an entity are classified as distressed when the issuer cannot meet a large number of its financial obligations. Unlike junk bonds, which have a credit rating of BBB (or lower), distressed securities have a credit rating of CCC or lower.
Furthermore, fixed income securities having a yield-to-maturity that 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 that 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 because distressed debt is a high risk/high return debt security. Given the financially distressed position of the issuer, 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 and the company is saved from bankruptcy and/or liquidation, then the debt security is likely 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 of the distressed issuer by purchasing a large number of the issuer’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 company 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, only 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 look for the following qualities in someone to advise you or manage your investments in distressed debt:
- Complete understanding of bankruptcies, restructuring, and reorganization.
- Credit research platform consisting of experienced and well-informed analysts.
- 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.
- Ability to assess and ascertain the reason behind the issuer’s distress and advise about downside risks and upside potential of investments accordingly.
- Liquidity and flexibility to exploit investment opportunities as they arise.
Applications in Financial Modeling
For professionals in investment banking or other areas of corporate finance, it’s important to factor in the impact of financial distress on the entire capital structure of a firm. In order to do this, an analyst must build a financial model to fully capture the impact.
Below is an example of a financial model showing the balance sheet of the business.
Learn more about financial modeling in our online financial analyst courses, and see the CFI resources below for more information on debt and risk.