The bond market is about twice the size of the stock market. Stocks get the most attention, but a lot of money is in bonds. And when it comes to investing in distressed debt securities, there are great value opportunities.
When investing in distressed debt, it takes some skill to separate the good from the irritation. It’s not for the faint of heart. You have to sort through many companies – and sometimes countries – that are going through tough times.
But before we get too deep, let’s first take a look at what makes debt distressed. Then, from there, we’ll dive into some strategies and different ways to invest.
What is distressed debt investing?
Debt is money lent to borrowers with the promise to repay. For example, a new company may borrow $100 million to scale its first product. Then, depending on the details of the loan, the business will repay it plus interest in subsequent years.
However, if that business does not grow as expected, it may not be able to repay the loan. For example, he may have overlooked some regulatory issues. Regardless of the case, if sales and profits do not follow, the business is less likely to be able to repay the loan. And that’s when the debt can become distressed.
Investing in debt and credit ratings
Investors who initially loaned $100 million see him as an asset. Although, as the probability of repayment decreases, this asset is worth less. And like any asset, you can trade it with other investors.
With larger companies, you will often find that their debt is traded in secondary markets. Because it is an asset, one investor might be willing to buy it from another.
But as mentioned…when the underlying companies are in trouble, the value of existing debt goes down. Investors are unwilling to pay the full amount of a loan if there is a higher chance that the borrower will not be able to repay it all.
To determine the likelihood of a default — a business missing loan payments — you can look at credit scores. There are three major rating agencies: Standard & Poor’s, Moody’s and Fitch. They each have different systems, but the lower the rating, the more distressed the debt becomes.
Companies can even file for bankruptcy and return money to investors. As a company goes through this process, it may be able to repay some, if not all, of its loans to bondholders. If the company goes through a reorganization or liquidation, it could sell some of its assets. This is why investing in distressed debt continues to see commercial activity.
Bonds are often considered safer because bondholders come before shareholders. They are the first to see the money returned during tough times.
Investing Opportunities in Troubled Debt
To invest in distressed debt, you can find opportunities with major brokers. Schwab, Fidelity and others provide access to corporate debt. However, this can be more difficult than investing in stocks.
Due to the increased risks associated with investing in distressed debt, there is generally less trading activity. This means fewer opportunities to buy the bonds from sellers. On top of that, when negotiating debts, there may be higher minimum requirements.
For this reason, you will often see more activity from larger funds. They also tend to have a better understanding of the legal process in bankruptcy and over-indebtedness. But nonetheless, feel free to explore what your broker offers.
If you buy distressed debt and the company recovers, it can generate big returns. You could pay pennies on the dollar for certain bonds. And it all comes down to finding better ways to measure both potential risk and reward. Then compare that to the current bond market price.
Diversify with Bond ETFs
As always, it’s good to diversify when investing. You can do this by investing in distressed debt across all sectors. And as mentioned earlier, you can also invest in distressed sovereign debt. Some countries around the world are also struggling to honor their debt repayments. However, analyzing a country’s finances can be more difficult.
Buying distressed debt can take a lot of due diligence. This is why many investors decide to opt for debt funds. Due to the complexity of investing in distressed debt, this might be a better way to go.
A popular fund is iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG). It has a wide range of bonds and some are more distressed than others. Due to the higher risk on average, it earns investors a higher return.
There are a lot more funds to start with when investing in distressed debt. However, it is good to balance portfolios beyond bonds. If you’re looking for more investment opportunities, check out these free investment newsletters. They are filled with expert ideas.
Brian Kehm graduated from Iowa State University with a double major in finance and accounting. After graduating, he went to work for a cryptocurrency company in Beijing. Upon returning to the United States, he began working with financial publishers and also passed the CFA exams. When Brian isn’t researching and sharing ideas online, you can usually find him rock climbing or exploring the great outdoors.