Not only big hedge funds love to invest in companies which are in financial troubles, but also lots of experienced individual investors often benefit from investing in distressed businesses. At first glance, it does not make sense to approach dying companies with investments, but in fact, investing in debt can become a most rewarding move you have ever made. How is that?
It is a law of wealth in the financial world: the higher the risk the bigger the potential profit and vice versa. Distressed companies like any other companies issue securities like stocks and bonds. We are interested in bonds, which financially sick companies offer at an extremely low price. Let us explain in detail why this type of investment is a large piece of a delicious money pie.
Why is that beneficial?
Companies, who are on the edge of bankruptcy suffer an unbearable debt pressure and therefore desperately seek for financing. No lenders want to take such huge risk and lend money to drowning business. The only way to attract investors is to issue bonds and sell it at an extremely low price. And the question remains: even at a very low price who on Earth would buy bonds of a Company who has serious chances to collapse in the nearest future?
Here is the concept: a distressed company is not dead yet, and so, there are tiny chances it will recover and get back on track. Logically, the Company’s securities will jump up in price and here is where the profit lies.
An investor who buys distressed debt should realize clearly that “it’s all or nothing” kind of a deal and the risk is really significant. The possibility of such quick and huge profit attracts corporate investors mostly. Still, private investors can join the hedge fund with a significant part of the distressed debt in a portfolio for a chance to hit the jackpot. There are hedge funds with several divisions who work solely on searching for attractive distressed debt to invest in. The task of an Investor is to minimize the chances of getting into the Company which will really go bust after all. Some think that distressed debt backed by collateral guarantees the non-bankrupt status. It’s a big mistake which may cost you everything and here is why (see below).
What about collateralized debt?
There is a good lesson for all investors out there who are sure that collateralized debt is a protection against losing money. In times of the world economic crisis that took place a decade ago, collaterals in form of property (commercial and residential Real Estate) plunged in price dramatically.
That means, even a collateralized debt imposes a threat for an investor. When the collateral decreases in value, nothing protects investor’s money. If the distressed Company finally collapses, bonds devaluate to zero.
Is the risk worth the reward?
It’s always a matter of own risk tolerance and financial capability which allows you to stay afloat if the worst scenario will eventually happen. Putting money into the distressed debt securities is one of the riskiest types of investing and there are many examples of failed investment hopes and wiped out money. According to Money Management concept, an investor must not invest more than 15% of his money in such risky assets.
Still, some investors find the potential reward attractive enough to risk.
There are three ways an investor can get securities of a distressed company:
- Hedge Funds (hedge funds buy bonds directly from mutual funds which are not allowed to keep in their portfolios devaluated securities);
- Bond market. The bond market is a great place to buy bonds directly, without mediators.
- Directly at the distressed Company (available for Corporate Investors).
Still, the best and most efficient way for an individual investor to access the distressed debt market (especially if you are having not enough money for full-size securities) is exchange-traded bonds. This option allows buying bonds partially instead of full-size bonds packages. For example, if bonds are traded at 900 dollars, a private investor can buy a fraction of it at $50 or even cheaper. This way of making portfolios with fractions of real securities is very popular in micro-investing as it brings the same outcome as investing in full-size stocks, bonds, and derivatives.