What Is Distressed Debt and How Does It Work?

Distressed debt refers to financial obligations issued by entities facing severe financial challenges. It indicates a borrower’s financial difficulty, signaling that the issuer may struggle to meet its payment responsibilities. Understanding distressed debt provides insight into the health of companies or other entities that have borrowed funds, highlighting situations where financial strain could lead to restructuring or other significant changes.

Defining Distressed Debt

Distressed debt represents financial instruments of an entity that is either in default or is anticipated to be unable to meet its principal or interest payments. This debt typically trades at a substantial discount to its original face value, reflecting heightened risk. For instance, its market value often falls more than 40% below par, or it may have a yield to maturity exceeding 1,000 basis points (10%) above comparable risk-free rates.

Debt is classified as distressed when the issuing entity cannot fulfill a significant portion of its financial obligations. Securities in this category often carry a credit rating of “CCC” or lower from rating agencies, indicating a high probability of default or bankruptcy. This signifies a severe level of financial trouble for the borrower, distinguishing it from merely “underperforming” or “speculative” debt.

Causes of Debt Distress

Several factors can lead to a borrower’s financial distress, causing their debt to become distressed. Economic downturns, such as recessions or industry-specific slumps, often reduce demand for products and services, impacting a company’s revenue and ability to service debt. Poor management decisions, including inefficient operations, failed strategic initiatives, or excessive spending, can also contribute to financial instability.

Entities may also experience distress due to excessive leverage, where they have taken on too much debt relative to their assets or earnings, making it difficult to manage debt service payments. Technological disruptions or shifts in industry trends can render a company’s products or services obsolete, leading to a decline in profitability. Additionally, unforeseen events like natural disasters or pandemics, as well as changes in regulations or legal issues, can significantly impact a company’s financial health.

Forms of Distressed Debt

Various financial instruments can become distressed, reflecting financial difficulties across different sectors.
Corporate bonds, which are debt securities issued by companies, frequently become distressed when the issuing company faces severe financial challenges.
Bank loans, including syndicated loans or term loans provided by financial institutions, can also fall into this category if the borrower struggles to repay them.
Asset-backed securities (ABS) and mortgage-backed securities (MBS), which are debt instruments secured by underlying assets or mortgages, may become distressed if the performance of the underlying assets deteriorates.
Sovereign debt, issued by national governments, can become distressed if a country faces economic instability or is unable to meet its repayment obligations.
Municipal bonds, which are debt issued by state or local governments, can similarly face distress if the issuing municipality encounters financial difficulties.
Trade claims, representing unpaid invoices or other commercial obligations, also constitute a form of distressed debt.

The Distressed Debt Market and Its Participants

The distressed debt market is where these financially troubled obligations are bought and sold, often operating as an “over-the-counter” market rather than on traditional exchanges. Specialized distressed debt investors are major participants, including hedge funds, private equity firms, and dedicated investment banks that focus on acquiring these assets. These investors often purchase debt at significant discounts, aiming for potential gains if the underlying company recovers. Original lenders or creditors, such as banks and other financial institutions, may seek to sell their distressed debt holdings to mitigate losses. The debtors themselves, the companies or entities whose debt is distressed, are also central figures in this market. Additionally, a range of advisors, including lawyers, financial advisors, and restructuring consultants, play a role by facilitating transactions and advising on potential restructurings.

Resolution Approaches for Distressed Debt

Once debt becomes distressed, several approaches can be pursued to resolve or restructure the obligations. Restructuring involves negotiating new terms with creditors outside of court, such as extending maturities, reducing interest rates, or converting debt to equity, to avoid formal bankruptcy proceedings. This out-of-court restructuring can be less expensive and more flexible than court-supervised processes.

Bankruptcy proceedings offer a legal framework for resolving distressed debt, with Chapter 11 in the United States allowing for reorganization where a company continues operations under court supervision, while Chapter 7 involves liquidation of assets. Debt-for-equity swaps are a common restructuring tool where creditors exchange their debt for an ownership stake in the troubled company, eliminating the need for fixed interest payments and improving cash flow. Asset sales involve the distressed company selling off portions of its property or equipment to generate cash for debt repayment. These sales can allow assets to be sold “free and clear” of liens, making them attractive to buyers. Informal agreements between debtors and creditors, known as workouts, also serve as a method to resolve payment issues without formal court intervention.