When people think about investing, they most often consider stocks and bonds. However, many options outside of these basic investments exist, from commodities like gold to distressed debt. For many investors, distressed debt remains a confusing investment. After all, investing in distressed debt literally means taking on the debt of a company in a dire financial situation. At the same time, taking on distressed debt as an investment can result in a profit if the company recovers or even if it ends up going bankrupt. You can typically purchase this distressed debt at a deep discount, which is how there is potential for profit.
The People Who Tend to Invest in Distressed Debt
Purchasing the debt of a company rather than its stock may seem strange at first, but it is a common investment technique among hedge funds and institutional investors. If the company recovers, then the investor makes the difference between the discount on the debt and the total value of the debt. Purchasing debt also leaves the potential for profit should the company go bankrupt. This is not true with a stock. If you purchase stock, you may make more of a profit should the company recover than you do with debt. However, if the company goes bankrupt, then the stock is not worth anything. Even if a company goes bankrupt, investors can get payments on debt in many cases. Also, there is always the potential for distressed-debt investors to become part owners of a company if a restructuring happens during bankruptcy.
Outside of investment firms and hedge funds, distressed debt is often purchased by non-traditional funds, such as business development companies (BDCs). These companies are non-registered entities that invest in small or medium-sized public and private companies. BDCs are required to invest at least 70 percent of their assets in certain types of investments, which include distressed debt. In other words, the main investors in distressed debt are large, institutional investors rather than individuals, although that does not mean individuals do not sometimes purchase distressed debt based on their personal investment goals.
The Basics to Know About Investing in Distressed Debt
No rules exist to define exactly what qualifies as a distressed debt. Typically, investors use the term to refer to debt that is trading at a very large discount compared to its par value. The discount can be as large as 80 percent or as small as 20 percent and still qualify the debt as distressed. Typically, a larger discount reflects a more difficult situation for the company that holds the debt. You always need to remember that this discount comes from the default risk. Thus, while larger discounts create potential for greater gains, they also come with a much higher level of risk. Investors can easily lose money if the company goes bankrupt and has no ability to meet its credit obligation. However, by betting on a turnaround and being right, investors can make a significant profit.
Importantly, investors in distressed debt have the ability to get priority status for paying back debts should the company go bankrupt. Courts order the priority of creditors for payback during a Chapter 11 bankruptcy. Often, investors in distressed debt are among the first people to get paid back, even ahead of shareholders and employees. In some cases, this can even result in creditors taking ownership of the company, which puts them in a position to make an even larger profit if they are able to turn the company around and stabilize its finances.
Figuring out if Distressed Debt is the Right Investment for You
Investing in distressed debt carries a massive risk. While the potential for payoff is impressive, the chances that an investor walks away with nothing should the company go bankrupt are also quite high. Thus, investing in distressed debt is not for everyone. This risk is why typically only larger hedge funds engage in this type of investing. These organizations can perform in-depth risk analyses to make the most informed decisions and often partner with other firms to diversify risk and spread it out across multiple parties. Even then, distressed debt typically makes up only a small percentage of a hedge fund’s total portfolio.
For the most part, individual investors do not get involved with distressed debt investing. However, that does not mean it is impossible, especially for people with quite large portfolios. The vast majority of individual investors are better off with investments that carry less risk, but the distressed debt market is accessible for people who choose to accept the risk. You can also invest in distressed debt in a less risky way by purchasing shares of mutual funds that include distressed debt in their holdings. At the same time, you can also buy distressed debt directly if you choose. Should you choose this path, it is not advisable for a retirement portfolio or similar type of portfolio with which risk must be limited.