Distressed debt - Distressed debt
Distressed debt or in Spanish, debt with difficulties, refers to debt securities issued by companies that are in financial difficulties.
Financial difficulties can be understood as a multitude of situations, depending on each company.
Thus, for this type of debt to be considered distressed, the company in question must meet one of the following three situations:
- Companies that are in financial default.
- Companies that are almost in financial default.
- Companies that have declared bankruptcy.
Investors who invest in this type of debt are known as "vultures." Hence, funds that invest in companies experiencing financial difficulties are known as 'vulture funds'. Therefore, they first buy the debt of these companies to later seek a rapid improvement of it, obtaining a high profitability for it.
Distressed debt and vulture funds
The main objective sought by "vulture funds" is to obtain high returns due to the following possibilities:
- The company becomes more stable.
- The value of your debt increases in value.
- If the company goes bankrupt, obtain a discount on its capital participation.
In summary, the term distressed debt has two meanings:
- The issuer of the debt is in financial trouble.
- The price of the debt reaches very low limits due to its status as distressed and is sold at a fraction of its face value.
Risks of distressed debt
The strategies followed by investors in this type of debt carry with them two main sources of risk: business risk and liquidity risk.
In principle, it should be taken into account that the state of the economy in general is not a concern for investors in distressed debt, since they really have to worry about the problems of the company in question.
However, poor market and economic conditions can increase the size of the distressed debt market and cause a higher level of debt to become distressed debt.
Requirements to consider a distressed debt
The term distressed debt can be very ambiguous, and therefore there does not seem to be a universal definition. However, in general terms, this type of debt usually meets the following criteria:
- The credit rating of the debt issue (if available) is equal to or lower than CCC (S & P) or Caa (Moody’s). A low rating indicates that no interest is being paid and / or the issuer is in default. Remember the importance of credit ratings by rating agencies.
- The present value of the debt issue on the market is less than 50% of its principal.
- The yield to maturity of the debt issue is at least 10% higher than the risk-free interest rate.