Why hedge funds love distressed debt

Hedge funds can generate massive returns in relatively short periods of time, and they can also go into financial crises just as quickly. What kind of investments can produce such diverse returns? One answer is distressed debt. The term can be loosely defined as the debt of companies that have filed for bankruptcy or have a significant chance of filing for bankruptcy in the near future.

You might wonder why a hedge fund – or any investor, for that matter – would want to invest in¬†bonds with such a high likelihood of¬†defaulting. The answer is simple: the more risk you take on, the more reward you can potentially make. Distressed debt sells at a very low percentage of¬†par value. If the once-distressed company emerges from bankruptcy as a viable firm, that once-distressed debt will be selling for a considerably higher price. These potentially large returns attract investors, particularly investors such as hedge funds. In this article we’ll look at the connection between hedge funds and distressed debt, what ordinary investors can do to get involved and if the risks are really worth the rewards.

A Note About Subprime Mortgage Debt
Many would assume that¬†collateralized debt would be¬†immune from becoming distressed due to the collateral backing it, but¬†this assumption is incorrect. If the value of the collateral decreases and the debtor also goes into default, the bond’s price will fall significantly. Debt such as¬†mortgage-backed securities during the¬†U.S.¬†subprime mortgage crisis would be a great example.

The Hedge Fund Perspective
Access to distressed debt comes in many forms for hedge funds and other large institutional investors. In general these forms can be broken into three methods: the bond market, mutual funds and the distressed firm itself. Let’s take a closer look at these three:
1.     Bond market - The easiest way to acquire distressed debt is through the market. Such debt easily can be acquired from the bond market due to regulations concerning the holdings of mutual funds. Most mutual funds are not allowed to hold securities that have defaulted. Due to these rules, a large supply of debt is available shortly after a firm defaults.

2.     Mutual funds - Hedge funds can also buy directly from mutual funds. This method benefits both parties involved. In a single transaction, hedge funds can acquire larger quantities Рand mutual funds can sell larger quantities Рboth without having to worry about how such large quantities will affect market prices. Both parties also avoid paying exchange-generated commissions.

3.     Distressed firm - The third option is perhaps the most interesting. This involves directly working with the company to extend it credit on behalf of the fund. This credit can be in the form of bonds or even a revolving credit line. The distressed firm usually needs a lot of cash to turn things around; if more than one hedge fund extends credit, then none of the funds are overexposed to the default risk tied to one investment. This is why multiple hedge funds and investment banks usually undertake the endeavor together.

Hedge funds sometimes take on an active role with the distressed firm. Some funds who own the debt can provide direction to management, which may be inexperienced with bankruptcy situations. By having more control over their investment, the hedge funds involved can improve their chances of success. Hedge funds can also alter the terms of repayment for the debt to provide the company with more flexibility, freeing it up to correct other problems.

So, what is the risk to the hedge funds involved? Owning the debt of a distressed company is more advantageous than owning its equity in case of bankruptcy. This is because debt has precedence over equity in its claim to assets if the company is dissolved (the rule is called absolute priority). This does not, however, guarantee a financial reimbursement. (To learn why debtholders get paid first, read An Overview Of Corporate Bankruptcy.)

Hedge funds limit losses by taking small positions relative to their overall size. Because distressed debt can offer such potentially high-percentage returns, even relatively small investments can add hundreds of¬†basis points to a fund’s overall return on capital. A simple example of this would be taking 1% of the hedge fund’s capital and investing it in the distressed debt of a particular firm. If this distressed firm emerges from bankruptcy and its debt goes from¬†20 cents on the dollar to¬†80 cents on the dollar, the hedge fund makes a 300% return on its investment and a 3% return on its total capital. (For examples of hedge funds that ignored the risks, read¬†Dissecting The Bear Stearns Hedge Fund Collapse and¬†Hedge Fund Failures Illuminate Leverage Pitfalls.)

The Individual Investor Perspective
The same attributes that attract hedge funds also attract individual investors to distressed debt. It is highly unlikely that an individual would take on an active role with a company in the same way that a hedge fund might, but there are still plenty of ways for a regular investor to invest in distressed debt.

The first hurdle is actually finding and¬†identifying distressed debt. If the firm is bankrupt, you can easily tell this from the news, company announcements and other media. If the company has not yet declared bankruptcy, you can infer just how close it might be by using bond ratings such as Standard and Poor’s or Moody’s. (For more tips on finding weak companies, read¬†Profit From Corporate Bankruptcy Proceedings and¬†Z Marks The End.)

After identifying distressed debt, the individual will need to be able to access it. Using the bond market, like some hedge funds do, is one option. Another option is exchange-traded debt, which has smaller par denominations like $25 and $50 instead of the $1,000 par that bonds are usually set at. These smaller-denominated investments allow for smaller positions to be taken, making investment in distressed debt more accessible to individual investors.

The risks for individuals are considerably higher than those for hedge funds. Multiple investments in distressed debt likely represent a much higher percentage of an individual portfolio compared to a hedge fund’s. This can be compensated for by using more discretion in choosing securities, such as taking on higher-rated distressed debt that may pose less default risk yet still provide potentially large returns.

The world of distressed debt has its ups and downs, but hedge funds and sophisticated individual investors have a lot to gain from the risks taken. By controlling their risks, each in their own ways, both can earn great rewards for successful navigation through a firm’s tough times.