Debt can be classified as distressed when a company gets into trouble and their bonds trade at much wider spreads.
Generally, those spreads would be greater than 1,000 basis points (or 10%) above the respective government benchmark or risk-free asset (i.e. Treasury bills).
It doesn’t mean the company doesn’t have value or can’t bounce back, but it’s an area of investing that becomes available when a firm finds itself in bankruptcy proceedings or knows it’s about to experience financial difficulties.
Often, the company will be carrying a lot of debt – more than it can handle under the newly prevailing conditions.
For institutional investors, who are sophisticated enough to understand whether the company has value despite its current predicament, investing in distressed debt is a lot like getting designer clothes on sale. They can analyze risk using advanced models and testing so they are able to buy the bonds of a high-quality company that has fallen on hard times at a significant discount to par value (or face value).
These companies’ distressed bonds often carry a credit rating of CCC or lower, and its high yield bonds trade at a spread greater than 1,000 basis points (or 10%) above the respective government benchmark or risk-free asset.
In some cases, the firms are able to borrow enough to restructure and stay afloat – and as the company’s financials recover investors can make a profit on bonds they purchased at a steep discount.
If the company doesn’t bounce back, distressed debt investors are often among the first ones to get paid back – ahead of shareholders and employees – and may even end up assuming control of the business.
Individual investors can’t invest in distressed debt directly, but they can purchase mutual funds that hold distressed debt.
The debt (or bond) is not the same as a company’s stock, which investors can buy on their own, but are much lower on the repayment priority list than bonds.
If there is no money left to go around by the time everyone else gets their share, stockholders end up empty handed – no matter how much the stock may have climbed at some other point in the company’s history.