Distressed Debt Investing is intentionally purchasing the debt of a troubled company, often at a considerable discount. This allows investors to turn a profit if the company recovers or goes bankrupt.
A distressed debt is carried in the book of the lender as an asset. However, the value of the asset depends on the likelihood of the debtor paying later. Thus the need to rate the obligor to determine the likelihood of its ability to pay the loan and the chance of default.
Credit Rating Agencies have different considerations in assessing creditworthiness. The lower the rating, the more distressed the debt becomes. However, investments in distressed debt can turn around to provide some big returns.
Credit Ratings might aid an investor to measure both the potential risk and reward associated with a distressed debt while comparing it to the current market price of the Bonds. Investors can earn money even from companies that are in financial trouble. This happens when investors have bought the company’s debt rather than its stock.
An investor who buys equity shares of a company instead of debt could make more money if the company does turn itself around, but shares could lose their entire value if the company goes bankrupt. Debt still retains some value even if a turnaround doesn’t happen. Investors can walk away with payments even if a company goes bankrupt in many cases. Restructuring during bankruptcy can even result in distressed-debt investors becoming part owners of the troubled company.
Due to increased risks with investing in distressed debt, there tends to be less trading activity. This means fewer opportunities to buy the bonds from sellers. On top of that, when trading debt, there can be higher minimum requirements.
Although it can be more challenging than investing in stocks, bonds are often considered safer because bondholders come before stockholders. They are first in line to see money returned during tough times.
Major considerations in investing in distressed debts include the following:
- The rating of the underlying companies: When the underlying companies struggle, the value of the existing debt drops.
- The size and the track records of the broker: Distressed Debt Investing is often by Hedge funds, Business Development Companies (BDCs) and Investment firms.
- Diversity with Bond ETFs (Exchange Traded Funds): As always, it is good to diversify when investing. To do this, one can invest in distressed debt across industries. One can also invest in distressed sovereign debt. Some countries around the world struggle to meet their debt payments as well. However, analysing a country’s financials can be more difficult.
Buying distressed debt can require a lot of due diligence. This is why many investors decide to go with debt funds. Due to the complexity of distressed debt investing, this might be a better path to take.