What is distressed debt?
Distressed debt refers to bonds bought from companies that are either in bankruptcy or on the verge of it. These companies simply have too much debt to continue operating, which is a major cause of failure for many businesses. Some investors specialize in buying distressed debt, with the intention of gaining control of the company once it does enter bankruptcy.
Many companies encounter financial difficulties periodically, but they eventually recover and continue with business as usual. Distressed debt refers to what happens when a company cannot rebound and regroup.
When a company becomes overburdened with debt, it can negatively affect every aspect of the organization’s operation, and once a company becomes deeply distressed, it is unlikely to recover.
In most cases, distressed debt can be purchased at a steep discount in relation to what it’s worth because the owner of the debt is in a dire financial situation and in imminent risk of defaulting on debt payments. It must either quickly find the funds to pay off the debts or unload some of them before defaulting, even if this means taking a significant loss.
If a company sells its distressed debt, the company will owe anyone who buys it. If the company cannot pay, it may have to give control to the investors who bought this debt.
Many organizations buy distressed debt because they are confident that the company won’t be able to turn around its situation, meaning the buyer eventually will gain control of a company that no longer owes any debt. This is a relatively small investment for the buyer.
Distressed debt example
Some financial and investment firms actually specialize in buying distressed debt specifically to fund companies as they go through bankruptcy. These often are called debtor-in-possession (DIP) loans because once the company goes into bankruptcy, anyone who bought the distressed debt has a say in how the company restructures.
If a buyer thinks the company will do well once it gets rid of its debt, then it can buy the distressed debt, take control once the company is in bankruptcy and then steer the company toward financial solvency.