What Is Distressed Debt Investing?

Distressed Debt Investing Explained

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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. This buying method is often referred to as distressed debt investing. It’s a common practice among hedge funds and many institutional investors.

What Is Distressed Debt Investing?

Distressed debt investing involves buying the debt of a troubled company. It can often be bought at a steep discount. This allows you to turn a profit if the company recovers. 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.

Distressed debt is often held by investment firms and hedge funds. It can also be held by non-traditional investment funds, such as business development companies (BDCs).

BDCs are non-registered investment companies that invest in the debt and equity of small or medium-sized public and private companies. At least 70% of BDCs' assets must be invested in certain types of investments, including distressed debt.

How Distressed Debt Investing Works

There is no strict rule that defines when a debt is distressed. The term often means that the debt is trading at a large discount to its par value. This can range from a 20% discount to as much as an 80% discount. You may be able to purchase a $500 bond for $200. The discount comes because the borrower is at risk of defaulting.

Investors can lose money if the company goes bankrupt and is unable to meet its credit obligations. But investors can see the value of the debt go up a great deal if they believe there can be a turnaround and it turns out that they're right.

Distressed debt investors can also achieve priority status in being paid back if a company goes bankrupt. A court will order the priority of creditors to receive payment when a company declares Chapter 11 bankruptcy. Those involved in distressed debt are often some of the first to be paid back, ahead of shareholders and even ahead of employees.

This process can result in creditors taking ownership of a company. It can allow them to make even more of a profit if they are then able to turn the company's finances around.

Entities like hedge funds that buy large quantities of distressed debt will often negotiate terms that allow them to take an active role with the troubled company.

Is Distressed Debt Investing Worth It?

An investor runs the risk of having the borrower default when they purchase debt, whether that debt is a corporate bond or distressed debt. There is a very real risk of an investor walking away with nothing if the company goes bankrupt.

The risk of default explains why debt from less creditworthy organizations will bring a higher return for the investor.

Investors who engage in distressed debt investing, such as larger hedge funds, perform robust risk analyses using modeling and test scenarios. These funds are often skilled at spreading out risk through diversified investments or partnering with other firms.

Distressed debt often does not make up a large percentage of a hedge fund’s full portfolio. Investors aren’t as exposed if one investment defaults.

What It Means for Individual Investors

Individuals are not going to be involved in distressed debt investing. Most are safer investing in stocks and standard bonds. It's simple and comes with lower levels of risk. But you can access the distressed debt market if you choose. Some companies offer mutual funds that invest in distressed debt, or they include distressed debt as part of a portfolio.

The Franklin Mutual Quest Fund from Franklin Templeton Investments [MQIFX] includes distressed debt in its holdings, along with undervalued companies and cash. Oaktree Capital is another firm that offers investors access to distressed debt.

It’s helpful for investors to understand the possibilities that distressed debt offers. But it rarely makes sense in an investment or retirement portfolio. Sticking with stocks, mutual funds, and investment-grade bonds is a safer and more sensible path to wealth for most people. 

Key Takeaways

  • Distressed debt investing involves purchasing the debt of a troubled company, often at a steep discount.
  • Buying a troubled company's debt allows investors to turn a profit if the company recovers
  • Investors are repaid if and when the company goes bankrupt.
  • Distressed debt is often held by investment firms, hedge funds, or business development companies (BDCs).