The bond market is roughly two times the size of the stock market. Stocks get most of the attention but big money is in bonds. And when it comes to distressed debt investing, there are some great value opportunities.
When investing in distressed debt, it takes some skill to separate the wheat from the chafe. It isn’t for the faint of heart. You have to sort through many companies – and sometimes countries – going through tough times.
But before I get too ahead of myself, 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 loaned out to borrowers with the promise to repay. For example, a new company might borrow $100 million to scale its first product. Then depending on the loan details, the company will pay it back plus interest in the following years.
Although, if this company doesn’t scale as expected, it might not be able to pay back the loan. For example, it might have overlooked some regulatory issues. No matter the case, if sales and profits don’t follow, the company is less likely to be able to pay back the loan. And this is when the debt can become distressed.
Investing in Debt and Credit Ratings
The investors that initially lent $100 million consider it an asset. Although, as the probability of repayment decreases, that asset is worth less. And like any asset, you can trade it with other investors.
With large companies, you’ll often find that their debt trades on secondary markets. Because it’s an asset, one investor might be willing to buy it from another.
But as mentioned… when the underlying companies struggle, the value of the existing debt drops. Investors are unwilling to pay the full amount for a loan if there’s a higher chance the borrower won’t be able to pay it all back.
To determine the chance of a default – a company missing its loan payments –, you can look at credit ratings. There are three top 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 still return money to investors. As a company goes through that process, it might be able to pay back some – if not all – of its loans to bondholders. If the company is reorganizing or liquidating, it might sell off some of its assets. This is why distressed debt investing continues to see …….