Distressed Debt

What is Distressed Debt?

Distressed Debt refers to securities which has made default, or under the process of bankruptcy, or facing situations which could lead to bankruptcy and are usually traded at large discounts in comparison to their par value. There is a great deal of risk involved in the purchase or sale of these securities as financial distress or bankruptcy may lead to these securities becoming worthless or zero.

Explanation

Distressed Debt

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Features of Distressed Debt

How Does it Work?

Examples

  • In the late 1980s, Martin Whitman, an American investor, purchased distressed debt securities of an oil service firm that was facing financial difficulty, gained control of the company, and went into debt to equity deals with other creditors. The company came out of bankruptcy, and Whitman made a substantial profit.
  • In the mid-1990s, Franklin’s mutual funds purchased distressed debts from Canadian real estate Companies, who built Canary Wharf, London office complex. Franklin Investment reaped out a substantial profit when the holding company became bankrupt.

Types

  • Distress debt investments where investors are buying debts at significant discounts and looking to earn substantial profit in case the table turns around.
  • An investment where investors are looking to gain the control or ownership of the defaulted company through negotiation in courts if the company goes into bankruptcy.
  • An active non-control strategy where these investors involve themselves in the restructuring process of the company so that they can negotiate and maximize and safeguard the interest of the class of securities held by them.

Who Invests in Distressed Debt?

Advantages

  • Buying debts or bonds at a high discount to its par value gives way for the high potential of reward.
  • In case the company goes into bankruptcy, distressed debt investors can get ownership or control of the troubled company through negotiation.
  • It is one of the high risks, thus high reward deal, as we all know, “higher the risks, higher the rewards.”

Disadvantages

  • The distressed debt fund market is very unpredictable in nature; it needs an experienced investor with access to diverse risk management techniques to enter into this market.
  • High competition between firms leads to difficulties in negotiation at the time of the bankruptcy of the company.
  • A lot of research and analysis is required before investing in these kinds of funds; therefore, it is not optimal for an individual investor.
  • The risk associated with this type of investment is enormously high.

Important Points

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