Understanding Distressed Debt Investing and the Risks Involved

Government entities or companies that are in worse than average shape, hold what is often called “distressed securities.” Whenever a company enters a period of financial distress, whether through default or bankruptcy, shareholders will often try to sell their securities to a new set of investors. This type of investment is usually called distressed debt investing, and is somewhat common in the United States.

A company or government entity does not necessarily have to be in default, or bankrupt in order for this type of transaction to take place. It could be on its way to such status, however, and some investors try to influence how the company restructures its debt. Some investors try to invest new capital in the form of equity.

So, who buys these types of securities? In the past, private investors such as hedge funds, brokerage firms, and mutual funds have sometimes participated in distressed debt investing. Hedge funds in particular have been a large buyer of such securities. Investors must make an assessment on whether or not distressed companies will be able to improve their operations through a sound restructuring process.

Since a lot of research goes into this form of investing, many individuals are reluctant to become involved with it. Those who are interested in distressed debt investing tend to hope for higher returns in exchange for the high risks involved. Those who have the bravery and knowledge needed for buying the right securities from a company in trouble can achieve a high amount of success.

Why take such risks?

For the beginning investor, buying shares of a company that is facing bankruptcy or in default does not sound like a very smart idea. However, the rewards can be significant should the company bounce back sometime in the future. Indeed, the cost of the securities fall as shareholders, anticipate the financial distress of the issuer. Those who choose to buy the shares at a low cost can potentially profit a great deal if the company gets over the distress period and booms again. In this case, the shares will obviously climb back up.

Distressed debt investing is obviously rather risky and only professionals who specialize in researching these types of securities should attempt such risks. Sadly, many investors fail to take notice of a company’s true worth, which makes this type of investing something that beginners should steer away from-at least until they become more knowledgeable and experienced.
Analysis – Extensive research and analysis needs to be done in order to understand the different types of claims involved in a bankruptcy. Investors need to know why it is, exactly, that the distressed issuer is experiencing problems, and whether or not the
securities are truly worth selling or buying.

What events drive a company under? Is it poor management or something that is beyond anyone’s control, such as a recession? With better management and superior decision making, can the company get out of its predicament, or is it too late? These are the types of questions that need to be asked when considering distressed debt investing.