Distressed Debt and Bankruptcy Trading

Distressed debt refers to the bonds and loans of companies that are in financial trouble, close to default or already in bankruptcy. These securities often trade at deep discounts, sometimes 20 to 60 cents on the dollar or less. Distressed investors buy them betting that the eventual recovery, through a turnaround, a restructuring or a bankruptcy settlement, will be worth more than the purchase price. It is a specialised field that combines credit analysis, legal knowledge and negotiation.

What counts as distressed#

A common rule of thumb defines distressed bonds as those trading at a spread of 1,000 basis points or more over Treasuries, or at prices below about 70 to 80 cents on the dollar. Companies may be distressed because of too much debt, falling revenues, industry disruption or a liquidity crunch. See Investment Grade vs High-Yield Bonds.

Paths for a distressed company#

See Bankruptcy and Restructuring.

The capital structure and priority#

In bankruptcy, value is distributed according to the absolute priority rule, from the top of the capital structure down:

1. Administrative claims and debtor in possession (DIP) loans.
2. Secured debt (up to the value of collateral).
3. Senior unsecured debt.
4. Subordinated debt.
5. Preferred equity, then common equity (often wiped out).

The "fulcrum security" is the class of debt where value runs out: it typically receives most of the new equity in a reorganisation. Distressed investors try to identify and buy the fulcrum security.

Strategies#

Who invests#

Specialist hedge funds and private credit firms dominate, such as funds that played major roles in restructurings after the 2008 crisis and during the 2020 energy and retail bankruptcies. Distressed investing requires legal expertise, patience and the ability to hold illiquid securities for years. See Hedge Funds.

Risks#

• Valuation risk: enterprise value estimates can be far off.
• Legal risk: court rulings, priority disputes and creditor conflicts.
• Time risk: bankruptcies can take months or years.
• Liquidity risk: distressed securities can be hard to sell.
• Liability management: companies may use aggressive tactics, such as "uptier" transactions, that move value away from some creditors.
• Headline and reputational risk in high profile cases.

Frequently asked questions#

What is distressed debt?#

Bonds and loans of companies that are close to default or in bankruptcy, typically trading at large discounts to face value.

What is a fulcrum security?#

The class of debt in a company's capital structure where the value of the business runs out, which usually receives most of the equity in a reorganisation.

Is distressed debt investing risky?#

Yes. It involves uncertain valuations, legal processes, long timelines and illiquid securities, though it can offer high returns when analysis is correct.

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