Hedge funds can generate massive returns in relatively short periods of time, and they can lose a great deal of money just as quickly. What kind of investments can produce such diverse returns? One such investment is distressed debt. This type of debt can be loosely defined as the obligations of companies that have filed for bankruptcy or are very likely to file 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 greater the level of risk you assume, the higher the potential return. Distressed debt sells at a very low percentage of par value. If the once-distressed company emerges from bankruptcy as a viable firm, the once-distressed debt will sell for a considerably higher price. The potential for high returns attracts investors, particularly investors such as hedge funds. In this article, we'll look at the connection between hedge funds and distressed debt, how ordinary investors can invest in such securities, and whether the potential returns can justify the risk.

A Note About Subprime Mortgage Debt

Many would assume that collateralized debt would not become 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. Fixed income instruments such as mortgage-backed securities during the U.S. subprime mortgage crisis would be an excellent example.

The Hedge Fund Perspective

Access to distressed debt comes via several avenues for hedge funds and other large institutional investors. In general, investors access distressed debt through the bond market, mutual funds, or the distressed firm itself.

  1. Bond Market: the easiest way to acquire distressed debt is through the market. Such debt can be easily purchased due to regulations concerning mutual fund holdings. Most mutual funds are barred from holding securities that have defaulted. Consequently, 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—and mutual funds can sell larger quantities—without either having to worry about how such large transactions 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 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 that own debt can provide advice 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 takes precedence over equity in its claim on assets if the company is dissolved (the rule is called absolute priority). This does not, however, guarantee financial reimbursement.
    Hedge funds limit losses by taking small positions relative to their overall size. Because distressed debt can offer such potentially high 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 the debt goes from 20 cents on the dollar to 80 cents on the dollar, the hedge fund will make a 300% return on its investment and a 3% return on its total capital.

The Individual Investor Perspective

The same attributes that attract hedge funds also attract individual investors to distressed debt. While an individual investor is hardly likely to take an active role in advising a company in the same way that a hedge fund might, there are nonetheless plenty of ways for a regular investor to invest in distressed debt.

The first hurdle is finding and identifying distressed debt. If the firm is bankrupt, the fact will be in 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.

After identifying distressed debt, the individual will need to be able to purchase the debt. Using the bond market, like some hedge funds do, is one option. Another option is exchange-traded debt, which has smaller par values like $25 and $50 instead of the $1,000 par that bonds are usually set at. These smaller par value investments allow for smaller positions to be taken, making investments 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 than of a hedge fund portfolio. This can be offset by exercising 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 Bottom Line

The world of distressed debt has its ups and downs, but hedge funds and sophisticated individual investors have much to gain by assuming the risk potential. By managing these risks, both types of investors may earn great rewards by successfully weathering a firm's tough times.