Distressed Debt: Why You Need to Invest in It

Key Takeaways

• Investors in distressed debt seek to gain control in a company’s restructuring or when its going through bankruptcy.  

• Most debt investors hope to ultimately supplant existing management amid restructuring or get paid should the company file for bankruptcy.

• If the investor correctly sized up an opportunity and strategically bought a controlling debt share, they can have sway with the ensuing restructuring process and emerge an equity or debt holder.

In investing, one strategy involves hunting for companies facing financial woes in the form of debt, and possibly bankruptcy, and seeking to ultimately gain a controlling position. 

Mostly employed by hedge funds and private equity, although there are opportunities for retail investors, the high-risk, high-reward world of distressed debt investing is worth exploring.

With that said, here is an overview of distressed debt, and why investors may wish to consider getting into it.

What is Distressed Debt?

These are securities that are either in default, undergoing bankruptcy, or facing likely bankruptcy. Compared to their par value, such securities are typically traded at large discounts in a high-yield and leveraged market. Because of the risk involved, the securities have a below-investment-grade rating.

Usually, the debt includes trade claims, bonds, bank debt, and preferred shares. In general, distressed debt is less liquid than more traditional debt securities. Because the distressed debt market mainly involves securities of companies under financial duress, such securities may have minimal trading activity and fewer buyers. Market liquidity can vary, with some securities having higher trading volumes than others. 

Do note, though, that distressed debt is not issued by any particular entity.  

What is Distressed Debt Investing?

There are two types of debt investing, which is a capital investment in the debt of a financially distressed company, government, or other entity: private and distressed. Distressed debt investing is the process of investing capital in the entity’s existing debt.

When a company that is otherwise successful gets into trouble with debt, an investor in distressed debt can purchase some of that debt as it would bonds rather than stocks or shares, with the overarching aim of securing a controlling position. 

A financially distressed company has an unstable capital structure, meaning the company has too much debt, or its debt load is too hard to refinance. Such a financial condition could also mean the organization is unable to meet restrictions on existing debt covenants.

Note that such investments are generally not made to bail out the company’s owners or managers. They are not altruistic. After all, most debt investors hope to ultimately supplant existing management amid restructuring or get paid should the company file for bankruptcy. 

In such an environment, it can be in the investor’s best interest to purchase the company’s debt in increments from other investors, over a protracted period, to keep from tipping off to owners the move to gain a controlling debt share. To compound matters, investors typically do not know whether there are other investors who are also seeking to gain controlling shares.

Generally, the more challenging the general market milieu, the more likely investment prospects will emerge.

Distressed Debt Examples

Some 35 years ago, investor Martin Whitman bought the debt of an oil service company embroiled in financial problems. Having gained control of the firm, Whitman, along with other creditors, entered into debt-to-equity deals. After the company emerged from bankruptcy, Whitman made a large profit.

In another example, Franklin Mutual Funds bought distressed debts from the Canadian real estate company that built Canary Wharf, the London, England office complex. When the holding company went bankrupt, Franklin made a large profit.

Distressed Debt Features

• Issued at High Discounts from their Par Value. To save themselves from the prospect of steep losses by lending to a now-distressed company, the security’s initial issuers sell debt shares at a marked discount. 

• Belong to Companies Struggling with Financial Distress. Distressed companies are either facing financial troubles or will likely file for bankruptcy.

• Credit Rating Agency Allots Below Investment Grade Rating. The potential for large rewards notwithstanding, the investment risks involved lead credit risk agencies to bestow such securities with ratings that are below investment grade. 

• The Risk Factor. Risks associated with distressed debt investments are very high. Thus, the market is better suited for experienced investors equipped with risk management techniques.

Key Indicators to Focus on When Investing in Distressed Debt

Investors in distressed debt seek to gain control in two situations:

Restructuring of a Distressed Company. A distressed debt investor who owns a controlling share of a company’s financial obligations can impact the restructuring process and come out of it as an equity owner.

Bankruptcy of a Distressed Company. In situations in which restructuring is impossible and the company is forced to liquidate assets and pay stakeholders, debt holders get paid before equity holders.  

Benefits and Risks of Distressed Debt Investing

As with most anything else in investing, there are benefits and risks to consider in distressed debt investing.

Benefits 

• High returns through restructuring. This is the ultimate aim. If the investor correctly sized up an opportunity and strategically bought a controlling debt share, they can have sway with the ensuing restructuring process and emerge an equity or debt holder. Down the line, the investor will receive a return on their initial investment.
• Paid out in case of bankruptcy. In the case of bankruptcy, in which a company cannot be restructured and thus is forced to liquidate assets and pay out stakeholders, debt holders are paid first for their share, which was theoretically bought when prices were down. 

Risks 

• Limited opportunity for due diligence. Because due diligence is limited to an organization’s public records, investment decisions can be made on only a partial view of a company’s finances.
• Future financial distress. There is no guarantee a restructured company in which the investor has gained an equity position will perform well financially going forward.  
• Potential competition with other investors. Unbeknownst to the debt investor, there may be other investors who have designs on buying the same company’s debt over time and complete the mission first. They may even be able to impede the investor’s efforts once the investment process is triggered.

What Should You Look for When Investing in Distressed Debt?

Distressed debt investors look for these when gauging companies in which to take positions: financial distress, a successful business model, and an in-demand product or service. As one portfolio manager once notably put it, investors should “look for a good company with a bad balance sheet.”

Hedge funds can buy distressed debt, typically in the form of company bonds, at a low percentage of par value – the nominal or original value. If the company comes through bankruptcy viably, the fund can sell the bonds for a much higher price.

Retail investors can get involved, too. More on that below.

Invest in Distressed Debt

Generally, hedge funds and other large institutional investors can access distressed debt via mutual funds, the bond market, or the troubled company itself. 

With mutual funds, hedge funds in just one transaction can buy large quantities without concern about the effect on market prices. Mutual funds benefit, too, as they can sell larger quantities with no worries about impact on price. Also, both parties skirt paying exchange-generated commissions.

Going through bond markets is the easiest way in which hedge funds can buy distressed debt due to regulations that govern mutual fund holdings. Such regulations allow for the availability of large amounts of debt shortly after a company defaults.

Hedge funds may also be purchased directly from distressed firms, although this option is perhaps the most multifaceted. Such a purchase calls for working with the distressed company to extend fund credit. While such credit is usually in the form of bonds, it can also be a revolving credit line. 

In any case, the company will usually require a load of cash to improve their financial situation. If multiple funds extend credit, then no fund is overexposed to the risk of default. That is the reason hedge funds and investment banks typically go in on the effort together.

At times, hedge funds will take an active role in the distressed company, providing advice. Such increased investment control can heighten their chances of success. To free up the company to fix other problems, the fund may also modify debt repayment terms.   

Hedge funds seek to limit losses by taking relatively small positions, commensurate with the fund’s size. Because potential returns can be high, even comparably small investments can reap large returns.

Say a fund invested 1% of its capital in the distressed debt of a certain company. If the company goes through bankruptcy and their debt increases from 20 cents on the dollar to 80 cents, the hedge fund will get a 300% return on its original investment as well as a 3% return on total capital.

As for individual investors, many are not immune to the allure of possible high returns. While such investors are unlikely to assume an active role in advising a firm as a hedge fund would. Still, there are ways in which a retail investor can participate in the market.

The first step is to identify distressed debt. The investor will likely hear about bankrupt companies in the news, or bond ratings services such as Moody’s or Standards & Poor’s can suggest companies’ proximity to such filings.

Once such debt has been identified, the investor will need to buy the debt, perhaps using the bond market. Exchange-traded debt is another option, what with their smaller par values — $25 and $50, for example – rather than the $1,000 par values at which bonds are typically set.

The smaller par values permit the taking of smaller positions, rendering investments in the distressed debt market more accessible to everyday investors. 

Before taking capital positions in distressed debt, investors should conduct an analysis of the risk involved with investing in a beleaguered company to see whether the company can emerge from financial difficulties. 

Distressed Debt and Alternative Investments

Those who seek to learn more about distressed debt would do well to peruse Yieldstreet’s insights and education offerings, a trove of comprehensive resources and information concerning private markets, the stock market, and more.

The blog posts focus particularly on alternative investments – asset classes other than stocks and bonds – as Yieldstreet is a leading alternative investment platform on which nearly $4 billion has been invested to date. In fact, Yieldstreet offers more alternative asset classes than any other platform.

Due to their low correlation to public markets, alternative assets such as art, real estate, and transportation can reduce the volatility of investment portfolios, and help shield them from inflationary effects. 

Debt investing is also an alternative investment, one which can also serve another essential purpose: investment diversification. Spreading one’s assets among, as well as within, differing asset classes helps to reduce the risk of big losses and may increase the overall potential for returns. 

Alternative Investments and Portfolio Diversification

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

In Summary

There are definite risks and considerations in the distressed debt space, which is better suited for experienced investors. After all, these are companies or other entities that are in financial trouble. However, a company that has a successful business model in addition to a product or service that is in demand, could hold the potential for a good investment – and high returns. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.