What it means
All debt has a face value, which is the amount the borrower promised to repay. When a borrower's prospects deteriorate, existing lenders who want out must sell to whoever will buy, and the price falls until a buyer thinks the expected recovery justifies it.
Debt trading below roughly 80 cents on the dollar, or yielding many percentage points above government bonds, is conventionally described as distressed. The buyers are rarely ordinary income investors.
Distressed debt funds employ restructuring specialists and lawyers, because the returns depend less on interest payments than on what happens in a negotiation or an insolvency court. Their analysis focuses on where each piece of debt sits in the queue for repayment.
That queue, known as the capital structure, is the heart of the subject. Secured lenders with a charge over specific assets are paid first, then unsecured bondholders and trade creditors, with shareholders last and usually with nothing.
Buying senior secured debt at a deep discount can be relatively safe, while buying junior debt in the same company can be close to a total loss. A common strategy is the loan-to-own trade.
The investor buys enough of a class of debt to control the restructuring vote, then converts that debt into equity, emerging as the owner of a company with far less borrowing than before. The original shareholders are usually wiped out in the process.
The risks are severe and the outcomes are binary. Recovery depends on asset values, the legal jurisdiction, the behaviour of other creditors and the time the process takes, and a case dragging on for three years destroys returns even when the eventual recovery percentage looks acceptable.
In practice
Real-world examples.
Example
A hedge fund buys the senior secured loans of a struggling cinema chain at 55 cents on the dollar. Its analysts calculate that the freehold properties alone would repay 70 cents in a liquidation, so the downside is protected even if the business never recovers.
Example
A bondholder in a shipping company facing a downturn sells at 45 cents rather than wait for a restructuring. The pension fund selling is not allowed to hold defaulted securities under its own investment rules, which is a frequent source of forced selling.
Example
A specialist fund accumulates 40% of an unsecured bond class in an indebted care home operator. Holding a blocking position lets it reject the first restructuring proposal and negotiate a plan that converts its bonds into a majority equity stake.
Think of it
“Distressed debt is bonds of troubled companies trading cheap-betting on some recovery value.
Formula
Calculation
Current yield = annual coupon / market price, and recovery return = (recovery value - purchase price) / purchase price.
A bond has a face value of $1,000 and pays an 8% coupon, so $80 a year. After the issuer misses a covenant test the bond trades at $400.
Its current yield is $80 / $400 = 20%, assuming the coupon is still paid. If a restructuring later settles the class at 65 cents on the dollar, the holder receives $650, giving a gain of $650 - $400 = $250 per bond, which is $250 / $400 = 62.5% on the purchase price. Should the settlement instead come out at 30 cents, the holder receives $300 and loses $100 per bond, or 25%.Case study
Seen in the real world.
Fenwick Rail Components is a fictional parts supplier created solely to illustrate how distressed debt works. In this illustrative story it borrowed $120,000,000 to buy a rival just before its largest customer moved production abroad, and within a year its bonds were quoted at 38 cents on the dollar.
An imagined distressed debt fund bought $30,000,000 of face value for around $11,400,000 after concluding that the tooling, land and long-term contracts would support a recovery near 60 cents. It then joined a creditor committee, blocked a proposal that would have preserved the existing shareholders, and pushed for a debt-for-equity conversion instead.
Two years later, in this fictional outcome, the reorganised company issued new shares to creditors and the fund's stake was valued at roughly $19,000,000. The illustration also shows the risk: had the plant closed rather than been restructured, the same position could have returned a fraction of the purchase price.
Watch out
Common mistakes.
- Judging distressed debt by its yield. A quoted yield of 40% is meaningless if the coupon is about to stop being paid, so the analysis must be about recovery value rather than income.
- Assuming all debt in one company is equivalent. Seniority and security determine who is repaid first, and two bonds issued by the same borrower can have completely different outcomes.
- Ignoring how long a restructuring takes. A 50% recovery gain earned over four years is a far weaker result than the headline number suggests once time is taken into account.
Questions
People also ask.
What price counts as distressed?
There is no formal line, but debt trading below about 80 cents on the dollar, or at a yield more than ten percentage points above government bonds, is generally described that way.
Can an ordinary business buy the debt of a struggling customer or supplier?
It can, and trade buyers sometimes do so to gain influence over a restructuring, though it requires legal advice because holding debt while also trading with the company creates conflicts.
What does loan-to-own mean?
It describes buying discounted debt with the specific intention of converting it into shares during a restructuring and ending up owning the business.
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