What is distressed debt investing?

Definition:

Distressed debt investing is the intentional purchase of a company’s distressed debt, often at a significant discount. This allows investors to realize profits if the company recovers or goes bankrupt.

How does distressed debt investing work?

There is no hard rule defining when debt is distressed. Often, this means that the debt is trading at a significant discount to its face value. This discount can range from 20% to 80%. You might buy a $500 bond for $200. The discount comes because the borrower is at risk of default.

Investors can lose their money if the company goes bankrupt and is unable to meet its credit obligations. Investors may see the value of the debt rise significantly if they believe there is a chance of recovery, and if they turn out to be right.

Investors in distressed debt can also gain priority in recovering their debts if the company goes bankrupt. The court will issue a priority to creditors for receiving payments when the company declares bankruptcy. Distressed debt participants are often among the first to get paid, ahead of shareholders and even employees.

This process can lead to creditors becoming owners of the company. This may enable them to achieve greater profits if they are then able to improve the company’s financial situation.

Is distressed debt investing worth it?

The investor is exposed to default risk when buying debt, whether it’s corporate bonds or distressed debt. There is a very real risk that the investor may end up with nothing if the company goes bankrupt.

Investors who engage in distressed debt investing, such as large hedge funds, conduct thorough risk analyses using modeling and scenario testing. These funds are often skilled in risk distribution through diversified investments or partnerships with other companies.

Distressed debt often does not make up a large portion of a hedge fund’s overall portfolio. Thus, investors are not overly exposed to risk if one investment falters.

What does this mean for individual investors?

Individuals are unlikely to participate in distressed debt investing. Most feel safer investing in standard stocks and bonds, which are straightforward and come with lower levels of risk. However, you can access the distressed debt market if you choose to. Some companies offer mutual funds that invest in distressed debt, or include distressed debt as part of an investment portfolio.

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

It is beneficial for investors to understand the opportunities presented by distressed debt, but it rarely makes sense in an investment or retirement portfolio. Sticking to stocks, mutual funds, and investment-grade bonds is a safer and more acceptable path to wealth for most people.

Source: https://www.thebalancemoney.com/distressed-debt-investing-and-how-it-works-4176037