It is possible for investors to earn significant amounts of money, even from companies that are in financial trouble. This profiting, which can seem counterintuitive, happens when investors have purchased the company’s debt, rather than its stock.
This buying method is often referred to as distressed debt investing, and it’s a common practice among hedge funds and many institutional investors.
Learn how distressed debt investing works and which kind of investors it is right for.
What Is Distressed Debt Investing?
Distressed debt investing is deliberately purchasing the debt of a troubled company, often at a steep discount. This allows investors to turn a profit if the company recovers.
An investor who purchases equity shares of a company instead of debt could make more money than debt investors if a company turns itself around. But shares could lose their entire value if a company goes bankrupt.
Debt, on the other hand, still retains some value even if a turnaround doesn’t happen. In many cases, investors still walk away with payments even if a company goes bankrupt. 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 for when to categorize a debt as distressed, but it generally means that the debt is trading at a significant discount to its par value. This can range from a 20% discount to as much as an 80% discount.
For example, you may be able to purchase a $500 bond for $200. In this case, 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 if investors believe there can be a turnaround and are ultimately proven right, they can see the value of the debt go up dramatically.
Additionally, distressed debt investors can achieve priority status in being paid back if a company goes bankrupt. When a company declares Chapter 11 bankruptcy, a court will usually determine the priority order of creditors who are owed money.
Those involved in distressed debt are often some of the first people paid back, ahead of shareholders, and even employees. This process can also result in creditors taking ownership of a company, which can allow them to make even more of a profit if they are 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?
Anytime an investor purchases debt, whether that debt is a corporate bond or distressed debt, they run the risk of the borrower defaulting. With distressed debt investing, there is a very real risk of the investor walking away with nothing if the company goes bankrupt.
The risk of default is why debt from less creditworthy organizations will generate a higher return for the investor.
Investors who engage in distressed debt investing, especially 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.
It’s unlikely that distressed debt would comprise a significant percentage of a hedge fund’s full portfolio. As a result, they aren’t overexposed if one investment defaults.
What It Means for Individual Investors
Generally, individual investors are not going to be involved in distressed debt investing. Most individuals are safer investing in stocks and standard bonds because it is simple and comes with lower levels of risk.
Individual investors can access the distressed debt market if they choose. Some companies offer mutual funds that invest in distressed debt or include distressed debt as part of a portfolio.
The Franklin Mutual Quest Fund from Franklin Templeton Investments [MQIFX], for example, includes distressed debt in its holdings along with undervalued companies and cash. Oaktree Capital is another firm offering individual investors access to distressed debt through private vehicles.
It’s helpful for investors to understand the possibilities that distressed debt offers, but it rarely makes sense in a typical 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.
- Distressed debt investing is deliberately purchasing the debt of a troubled company, often at a steep discount. This allows investors to turn a profit if the company recovers.
- Purchasing a troubled company's debt allows investors to turn a profit if the company recovers or if they get repaid when the company goes bankrupt. In some cases, distressed debt investors end up as owners of the company due to restructuring.
- Distressed debt is often held by investment firms, hedge funds, or business development companies (BDCs). It is rarely held by individual investors unless they purchase shares in a mutual fund that includes distressed debt.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.