Investing in Distressed Debt
Distressed securities may be an attractive investment option for sophisticated investors who are looking for a bargain and are willing to accept some risk. Distressed debt investing combines the best of both worlds — the cash flow of debt investments with the appreciation potential of stocks. While there is no hard and fast rule for what makes a “distressed” investment, it’s generally accepted that distressed debt trades at a huge discount to par value because the borrower is under financial stress and at risk of default. Distressed securities are debt securities; most often corporate bonds, of companies that are in some sort of distress.
When a company is unable or even challenged in meeting its financial obligations, its debt securities may be substantially reduced in value. When does “reduced in value” become “distressed”? Typically, a company’s debt is considered distressed when its yield to maturity is more than 1000 basis points above the risk-free rate of return (which is the return of a “risk-free” asset such as U.S. Treasuries). A security is also often considered distressed if it is rated CCC or below by one or more of the major debt-rating agencies, which include Standard & Poors, Moodys and Fitch.
Many companies fail simply because they are overburdened with debt. Distressed debt investors can make a fortune by buying the debt of over leveraged companies with pennies for dollars with the goal of taking control of the company.
When a company becomes distressed, the investors holding its securities often react to the possibility of bankruptcy by selling those securities at a reduced price. Most mutual funds are not allowed to hold securities that have defaulted. Due to these rules, a large supply of debt is available shortly after a firm defaults. Because their price is often greatly reduced, distressed securities are attractive to investors who are looking for real bargains. Typically, these investors think the company that issued the distressed securities is not in as difficult a position as the market believes.
The company may not enter bankruptcy at all. It may enter Chapter 7 bankruptcy (which involves shutting its doors), but upon liquidation, have enough money to pay its debt holders. Or, it may enter Chapter 11 bankruptcy (which lets the company continue operating while working out a plan for reorganization with a committee of major creditors) and successfully reorganize. In all of these cases, the value of the company’s distressed securities may increase, allowing investors holding those securities to profit.
Investors in distressed securities must be willing to accept significant risk, however. Most distressed securities are issued by companies that end up filing for bankruptcy. When this happens, some distressed securities are rendered worthless. For example, when a company goes bankrupt, its common stock often has no value (which is why many investors limit their investments to more senior distressed securities. As a result, investors in distressed securities must have the knowledge and skill to accurately assess whether the issuer (the company in distress) can improve its operations and successfully reorganize—and if so, which of its securities will benefit.
Because of the risks involved, large institutional investors—such as hedge funds, private equity firms and investment banks—are the major buyers of distressed securities. Often, these investors—alone or in conjunction with other distressed investors—will try to influence the process by which the issuing company reorganizes. Sometimes, the investors will inject new capital into the company in exchange for, say, equity.
Consider this example: Let’s suppose you think XYZ Corp. is a good company, but it carries way too much debt relative to its earnings power. You believe that if the company were debt free, it could be worth as much as $1 billion. Unfortunately, it carries about $2 billion in debt it cannot afford to pay.
The company’s debt trades for about $0.20 on the dollar, as investors are running for the exits as quickly as they can. You start buying up the debt. Within months, you acquire all of its $2 billion in debt for just $400 million.
When XYZ Corp. inevitably goes into bankruptcy, you’ll be first in line to collect on your debt. But XYZ Corp. cannot afford to simply pay you off with cash; if it could, it wouldn’t be in bankrupcty.
The stockholders, being rational investors, don’t want to pony up $2 billion in cash to pay off the debt just to retain ownership of a company only worth $1 billion.
The stockholders turn over the keys to you. You now have control of a debt-free company worth $1 billion in exchange for a $400 million investment in its debt.
You were a lend-to-own investor, buying up the company’s debt to take control of the business when it couldn’t pay you back as scheduled. For your effort, you net a 150% return on your money, turning $400 million into $1 billion
DEFINITION of ‘Distressed Bonds’
A financial instrument in a company that is near or valued as if it go into default. This main issue is usually the results from a company’s inability to meet its financial obligations. As a result, these financial instruments often suffered a substantial reduction in value as many of the mutual funds due to their internal bylaws are forced to sell these assets no matter how attractive they might beleive they are.
Due to their significant reduction in value, distressed securities often become attractive to investors who are looking for a “bargain” or “pennies on the dollar” and are willing to accept a higher risk. Because most of the time these companies end up filing for restructuring their debt or Chapter 11 or 7, there are substantial risks involved in investing in them.
The logic behind this investment is that the company’s situation is not as bad as the market believes it to be and either the company will survive or there will be enough money upon liquidation to cover the original investment.
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