Distressed debt refers to securities of companies or governments that are experiencing financial or operational difficulties and are either in default or on the brink of default. This article provides an in-depth look into the types, key events, models, applicability, and more.
Distressed debt has been an investment class since the concept of borrowing and lending emerged. Its modern significance grew during periods of economic instability such as the Great Depression of the 1930s and the Global Financial Crisis of 2008. In these periods, distressed securities became notable due to increased defaults and bankruptcies.
Debt issued by companies experiencing financial or operational difficulties.
Debt issued by countries facing economic crises or political instability.
Mortgage-backed securities from properties in foreclosure or severe financial distress.
Debt is considered distressed if it:
Trades at a substantial discount to its face value.
The issuing entity is in or near default.
The yield on the debt is significantly higher than market rates due to perceived risk.
Investors typically buy these securities at deep discounts, aiming for significant returns if the issuer recovers or through restructuring settlements.
The recovery rate (RR) estimates the amount recovered in the event of default:
A higher credit spread indicates greater distress:
High potential returns.
Portfolio diversification.
Provides liquidity.
Aids in the efficient allocation of capital.
Default: Failure to meet the legal obligations of debt repayment.
High-Yield Debt: Debt securities rated below investment grade but above distressed.
Bankruptcy: Legal state for entities that cannot repay their debts.