What is Distressed Debt?

From Economypedia.com

[edit] What is Distressed Debt

In this article, we wanted to provide information on distressed debt. This type of debt is usually called distressed securities, which are securities associated with government entities or companies that are in default, already under bankruptcy protection, or in a bad situation and heading to default or bankruptcy. While there are several different types of distressed debt, the two most common include debt associated with a bank and bonds.

It is important to understand that while an official definition is sketchy, when talking about distressed debt, this usually involves fixed income instruments that have a yield to maturity more than 1,000 basis points over what is called “risk-free rate of return”. In addition to this description of distressed debt, another category exists. In this case, the yield would range between 600 and 800 basis points more than treasuries. Then, it is common for distressed securities to have a CCC or below rating, which comes from different agencies such as Moody’s, Standard & Poors, and Fitch.

Sometimes, companies will go through difficult times of financial distress and when this happens, it is common for original holders to sell off debt or to equity securities of the issuer to one or more new buyers. In just the past few years, different private investment partnerships have been formed. For instance, hedge funds have become the largest of all buyers specific to distress debt in the form of securities. However, buyers could also be mutual funds, private equity firms, brokerage firms, active buyers, and collateralized loan obligations or other types of specialized debt funds.

[edit] Dealing With Distressed Debt

For investors dealing with distressed securities, it is common for them to do what they can to influence the process. In this case, they would try to get the issuer to restructure the debt involved, narrow the focus of the distressed debt, or even create a new plan whereby the company’s operations could be turned around and salvaged. In addition, some investors will choose to invest new capital into a company going through a financial distress period, which would be as equity or debt.

Keep in mind that many countries deal with distressed debt in the form of securities but the United States is by far the most developed market. Even so, we have seen more activity in recent years for international markets, specifically throughout Europe. This is in part because of an increase in leveraged lending, accounting practice for non-performing loans being standardized, new insolvency laws being enacted, and banking standards for capital become far too restricted.

For investors interested in distressed debt such as securities, it is imperative for them to complete an assessment. This should include the issuer’s ability to improve the government entity or company’s operations but in addition to this, the investor needs to have confidence that regardless of the restructuring process involved, one class of securities would benefit more than another class would.

With the financial crisis that the world has been going through since 2007, it is no wonder that so many government entities and companies are dealing with distressed debt or distressed securities. However, people need to understand that there are options for getting the business back on track without fear of losing everything worked so hard to create. Therefore, when facing distressed debt, all options need to be identified and analyzed.

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