The Pros and Cons of Distressed Debt Investing
Anytime a company’s financial situation worsens to the point it may become insolvent or needs to declare bankruptcy it is considered in a “distressed” state for investors. This often happens when a company cannot meet its financial obligations. In the case of those companies who issue bonds, this often occurs when they are unable to make coupon payments or returns on the principal payment. The result of this failure is a very significant reduction in the value of securities offered by the company (issuer). This results in the creation of assets available at a huge discount, but also at a much higher risk.
Because of the discount, the ROI potential of distressed securities goes up, which means investors become interested in them even though they entail such a high risk. Investors, however, can prevent an impending bankruptcy and steer a company into restructuring with such investment by becoming the company’s major creditor. This would eventually allow the company to repay the distressed debt and ensure the investment is a success. Investors, therefore, look at distressed issuers that the market has undervalued, who in fact have greater potential than their value would indicate. Such companies are an ideal investment for investors seeking distressed bonds. Additionally, investors could be investigating a bond in anticipation of default by examining how much it would pay out at that time. With the discount, it may still turn a profit in this event.
According to Hird (2014), distressed debt investing has various potential benefits, but also considerable drawbacks due to the riskiness of this type of investment. Below, we elucidate briefly some of these potential pros as well as cons of distressed debt investing:
The Potential Benefits
One big advantage of such distressed debt investment is that bond owners will be paid out before stockholders in the event of an issuer default. So it’s always better to look at bonds when a company is in distress over stocks.
the attraction is clearly the enormous gains available on distressed debt investments. Just like in other securities, the greater the risk, the greater the payoff if the investment proves to pay out. Hedge fund investors, for this reason, are particularly interested in distressed debt opportunities. Further benefits, may include the following.
Flexible timing
Depending on whether or not an investor wants to liquidate or restructure a company, they can invest sooner or later. The sooner they invest, though, it costs more, the more the investment helps ensure the company can restructure instead of liquidating.
Buying in at a low price and potentially achieving extensive business power.
Investors can become a company’s major creditor at an extremely discounted price by purchasing in-distress bonds. In this event, the investor would have significant power during any liquidation or reorganization that may take place.
Considerable Drawbacks
The goal for investors when investing in distressed debt is to find that key moment to invest when the assets are at the lowest price they will be to make the chance of profit more significant. Due to the wild unpredictability of distressed debt, this is rather difficult to do. Getting accurate information on distressed debts is always a challenge, which limits the number of investors who can effectively invest in them to a relatively low amount of major players in each market. In addition to that, considerable drawbacks or difficulties with respect to distressed debt investing include the following:
A highly sensitive market environment—this can cause significant issues because it only takes a small price overpayment to bring about large losses.
Negotiations are typically difficult—whenever investors deal with a company with distressed debt, there is a certain amount of hostility which only complicates the negotiation process.
In-depth analysis and profound market knowledge is vital—to accurately identify the possible money making potential of a bond, high-skilled legal and financial expertise is needed as well as enough data to make an informed evaluation.The key here is that due to the distress the company is in—its assets are undervalued which means they are available at a large discount.However, coming out ahead of such a deal may take more skill than people realize.
The Bottom Line
It becomes clear there are significant risks out there and that distressed debt investments have strengths and vulnerabilities just like any other financial instrument. That being said, it’s also clear that savvy investors who perform their due diligence have tremendous potential to make a profit from taking these risks. Undoubtedly, as above-mentioned, profound distressed market knowledge as well as in-depth examinations are essential for any investor in this area.
By nature, all distressed debts are on the high-end of the risk scale for investors. However, it is important to note that such investments also carry with them an advantage of a rather low correlation with factors that affect the stock markets meaning such debts can be used to effectively diversify a portfolio. This can clearly be considered to be an additional benefit (pro) of distressed debt investing.
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