# Distressed Debt and Bankruptcy Trading

> Distressed debt is the bonds and loans of companies near default, bought at deep discounts. Learn how investors value it, the bankruptcy process and strategies.

Source: https://learn.tradelabsai.com/bonds-credit/distressed-debt/  
Track: Bonds, Rates and Credit · Level: Advanced · Updated: 2026-10-03  
Publisher: TradeLabs AI (https://tradelabsai.com). Education, not financial advice.  
Cite as: TradeLabs Learn, "Distressed Debt and Bankruptcy Trading", https://learn.tradelabsai.com/bonds-credit/distressed-debt/

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](https://learn.tradelabsai.com/bonds-credit/high-yield-bonds/).

## Paths for a distressed company

| Path | What happens | Effect on debt holders |
|---|---|---|
| Turnaround | Business recovers; debt repaid | Bonds rise toward par |
| Out of court restructuring | Debt exchanged for new terms or equity | Partial recovery |
| Chapter 11 bankruptcy (US) | Court supervised reorganisation | Recovery by priority; may receive new equity |
| Liquidation (Chapter 7) | Assets sold | Recovery based on asset values |

See [Bankruptcy and Restructuring](https://learn.tradelabsai.com/fundamentals/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.

**Example: Valuing a distressed bond**
A company has $500 million of secured loans, $800 million of senior unsecured bonds and equity. Analysts estimate the reorganised business is worth $1.0 billion.

- Secured loans recover in full: $500 million.
- Remaining value for unsecured bonds: $500 million, a recovery of 500 / 800 = 62.5 cents per dollar.
- Equity is wiped out.

If the unsecured bonds trade at 40 cents, an investor who believes the valuation could earn about 56% (62.5 / 40) if the case resolves as expected, before time and costs. If the business is worth only $800 million, recovery falls to 37.5 cents, a loss. The unsecured bonds are the fulcrum security, likely to receive the new equity.

## Strategies

| Strategy | Description |
|---|---|
| Passive value investing | Buy undervalued distressed bonds and wait for recovery |
| Active control | Buy enough of the fulcrum security to influence the restructuring and gain control of the company |
| Capital structure arbitrage | Long one part of the capital structure, short another |
| DIP lending | Provide senior secured financing to companies in bankruptcy |
| Rescue financing | Lend to struggling companies before bankruptcy on favourable terms |
| Litigation driven | Profit from legal claims and disputes |

## 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](https://learn.tradelabsai.com/industry/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.

Next, learn about pooled corporate loans in [CLOs](https://learn.tradelabsai.com/bonds-credit/clos/).

## Continue learning

- Next lesson: [CLOs](https://learn.tradelabsai.com/bonds-credit/clos/)
- Previous lesson: [Default Probability and Recovery Rate](https://learn.tradelabsai.com/bonds-credit/default-probability/)
- Related: [Default Probability and Recovery Rate](https://learn.tradelabsai.com/bonds-credit/default-probability/): Default probability is the chance a borrower fails to pay. Learn historical default rates, probabilities implied by spreads, the Merton model and recovery rates.
- Related: [Bankruptcy and Restructuring](https://learn.tradelabsai.com/fundamentals/bankruptcy-and-restructuring/): When companies cannot pay their debts, they restructure or go bankrupt. Learn Chapter 11 vs Chapter 7, the priority of claims and what happens to stocks.
- Related: [Investment Grade vs High-Yield Bonds](https://learn.tradelabsai.com/bonds-credit/high-yield-bonds/): High yield bonds are rated below investment grade and pay higher interest for higher default risk. Learn how they behave, default cycles, spreads and how to invest.
- Related: [Corporate Bonds](https://learn.tradelabsai.com/bonds-credit/corporate-bonds/): Corporate bonds are loans to companies that pay interest above government bonds. Learn investment grade vs high yield, spreads, covenants, callable bonds and risks.
- Related: [Hedge Funds](https://learn.tradelabsai.com/industry/hedge-funds/): Hedge funds are private investment pools using flexible strategies, leverage and short selling. Learn the main strategies, fee structures, regulation and risks.