Why hedge funds like to invest in distressed debt

Hedge funds can generate huge returns in a relatively short period of time, and can also lose large amounts of funds just as quickly. What kind of investment can produce such diversified returns? One of the investments is distressed debt. This type of debt can be roughly defined as the obligation of a company that has filed for bankruptcy or is likely to file for bankruptcy in the near future.

You may wonder why hedge funds — or any investor, for that matter — want to invest in bonds with such a high risk of default. The answer is simple: the higher the level of risk you take, the higher the potential return. In this article, we will explore the link between hedge funds and distressed debt, how ordinary investors invest in such securities, and whether the potential return is sufficient to justify the risk.

Key points

  • Hedge funds that invest in distressed debt buy the bonds of companies that have filed for bankruptcy or may file for bankruptcy in the near future.
  • Hedge funds buy these bonds at a steep discount to their par value in the hope that the company will successfully emerge from bankruptcy and become a viable company.
  • If a failed company turns its losses into profit, the value of its bonds will increase, giving hedge funds a chance to make substantial profits.
  • Because of the risks associated with holding distressed debt, hedge funds can limit the risk by holding relatively small positions in troubled companies.

Profit potential

Hedge funds that invest in distressed debt are looking for companies that can successfully restructure or rejuvenate in some way to become sound companies again. Hedge funds can buy distressed debt (usually in the form of bonds) at a very low percentage of face value. If a troubled company recovers from bankruptcy and becomes a viable company, hedge funds can sell the company’s bonds at a very high price. This potential for high returns (albeit risky) is particularly attractive to some hedge funds.

How hedge funds invest in distressed debt

Hedge funds and other large institutional investors can obtain distressed debt in a variety of ways. Generally speaking, investors obtain distressed debt through the bond market, mutual funds, or the troubled company itself.

Bond Market

The easiest way for hedge funds to obtain distressed debt is through the bond market. Due to regulations regarding mutual fund holdings, such debt is easy to buy. Most mutual funds are prohibited from holding defaulted securities. Therefore, a large amount of debt can be obtained shortly after the company defaults.

Mutual Fund

Hedge funds can also be purchased directly from mutual funds. This method is beneficial to both parties. In a single transaction, a hedge fund can obtain a larger amount—and a mutual fund can sell a larger amount—without worrying about how such a large transaction will affect market prices. Both parties also avoid paying commissions generated by the exchange.

Troubled company

The third option is probably the most interesting. This involves working directly with the company to provide credit on behalf of the fund. This credit can be in the form of bonds or even a revolving credit line. Distressed companies usually need large amounts of cash to turn things around. If more than one hedge fund provides credit, no fund is excessively exposed to the risk of default associated with an investment. This is why multiple hedge funds and investment banks usually work together.

Hedge funds sometimes play an active role in troubled companies. Some funds with debt can provide advice to management, and the latter may lack experience in bankruptcy situations. By having more control over their investments, the hedge funds involved can increase their chances of success. Hedge funds can also change the terms of debt repayment to provide companies with greater flexibility and time to solve other problems.

The “Vulture Fund” is a hedge fund that specializes in buying only distressed bonds, and it often “pounces” to buy government bonds in distressed countries.

The risks of hedge funds

So, what are the risks faced by the hedge funds involved? In the event of bankruptcy, it is more advantageous to own the debts of the troubled company than to own the equity. This is because if the company dissolves, debt takes precedence over equity claims on assets (this rule is called absolute priority or liquidation priority). However, this does not guarantee financial compensation.

Hedge funds limit losses by taking smaller positions relative to the overall size. Because distressed debt can provide such a high potential return, even a relatively small investment can increase the fund’s overall return on capital by hundreds of basis points.

A simple example is to invest 1% of hedge fund capital in distressed debt of a particular company. If this troubled company recovers from bankruptcy and its debt rises from 20 cents to 80 cents, the hedge fund’s return on investment will reach 300% and the return on total capital will be 3%.

Individual investor’s point of view

The same attributes that attract hedge funds also attract individual investors to buy distressed debt. Although individual investors are unlikely to actively advise companies as hedge funds, there are still many ways for ordinary investors to invest in distressed debt.

The first obstacle is the detection and identification of bad debts. If the company goes bankrupt, the facts will appear in the news, company announcements and other media. If the company has not declared bankruptcy, you can infer how close it might be by using bond ratings such as Standard & Poor’s or Moody’s.

After identifying the bad debt, the individual will need to be able to purchase the debt. Using the bond market like some hedge funds is an option. Another option is exchange-traded bonds, which have smaller face values, such as $25 and $50, instead of the usual $1,000 face value set for bonds.

These smaller denomination investments allow holding smaller positions, making it easier for individual investors to obtain distressed debt investments.

Individual investor’s risk

The risk of individuals is much higher than that of hedge funds. Compared with hedge fund portfolios, multiple investments in distressed debt may account for a much higher proportion of a single portfolio. This can be offset by exercising greater discretion in the selection of securities, such as taking on higher-rated distressed debt that may cause a lower risk of default but still provide potentially substantial returns.

Notes on subprime mortgages

Many people assume that mortgage debt will not get into trouble because of collateral backing, but this assumption is incorrect. If the value of the collateral falls and the debtor defaults, the price of the bond will fall sharply. Fixed-income instruments, such as mortgage-backed securities during the US subprime mortgage crisis, are a good example.

Bottom line

The world of bad debt has its ups and downs, but hedge funds and sophisticated individual investors can reap a lot of benefits by taking on potential risks. By managing these risks, both types of investors can get rich returns by successfully passing the company’s tough times.

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