Hedge funds can generate massive returns in relatively short periods of time, and they can lose a lot of money just as quickly. What types of investments can produce such varied returns? Such an investment is afflicted 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 be wondering why a hedge fund – or any investor, for that matter – would want to invest in obligations with such a high risk of default. The answer is simple: the higher the level of risk you assume, the higher the potential return. In this article, we’ll look at the link between hedge funds and distressed debt, how ordinary investors can invest in these securities, and whether the potential returns can justify the risk.
Key points to remember
- Hedge funds that invest in distressed debt buy the bonds of companies that have filed for bankruptcy or are likely to do so in the near future.
- Hedge funds buy these bonds at a steep discount to their face value in the hope that the company will successfully emerge from bankruptcy as a viable business.
- If the failing company changes its fortunes, the value of its bonds will increase, giving the hedge fund the opportunity to reap substantial profits.
- Because holding distressed debt is risky, hedge funds can limit their risk by taking relatively small positions in distressed companies.
The profit potential
Hedge funds that invest in distressed debt look for companies that could be successfully restructured or rejuvenated in some way back to being solid businesses. Hedge funds can buy distressed debt (usually in the form of bonds) at a very low percentage of by value. If the once-struggling company emerges from bankruptcy as a viable business, the hedge fund may sell the company’s bonds at a significantly higher price. This potential for high, albeit risky, returns is particularly attractive to certain hedge funds.
How hedge funds invest in distressed debt
Access to distressed debt comes through several routes for hedge funds and other big institutional investors. Typically, investors access distressed debt through the bond market, mutual funds, or the distressed company itself.
The easiest way for a hedge fund to acquire distressed debt is through bond markets. Such debt can be easily purchased due to regulations regarding mutual fund holdings. Most mutual funds are prohibited from holding defaulted securities. Therefore, a large supply of debt is available soon after a business fails.
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 having to worry about the impact of such transactions on market price. Both parties also avoid paying the commissions generated by the exchange.
Companies in difficulty
The third option is perhaps the most interesting. This involves working directly with the company to extend credit on behalf of the fund. This credit can take the form of bonds or even a revolving line of credit. The struggling business usually needs a lot of money to turn the situation around. If more than one hedge fund extends credit, neither fund is overexposed to the default risk linked to an investment. This is why several hedge funds and investment banks usually undertake the effort together.
Hedge funds sometimes play an active role with the company in difficulty. Some funds that hold debt may provide advice to management, which may be inexperienced in bankruptcy situations. By having more control over their investment, the hedge funds involved can improve their chances of success. Hedge funds can also change the terms of repayment that debt gives the business more flexibility, freeing it up to fix other problems.
“Vulture fundsare hedge funds that specialize only in buying distressed debt, and frequently “step in” to buy government debt from troubled countries.
Risks for Hedge Funds
So what is the risk for the hedge funds involved? Owning the debt of a struggling company is more advantageous than owning its equity in the event of bankruptcy. Indeed, debt takes precedence over equity in its claim on assets in the event of the dissolution of the company (this rule is called top priority or liquidation preference). However, this does not guarantee financial reimbursement.
Hedge funds limit losses by taking small positions relative to their overall size. Because distressed debt can offer potentially high returns, even relatively small investments can add hundreds of dollars. basis points a fund’s overall capital return.
A simple example would be to take 1% of the capital of the hedge fund and invest it in the distressed debt of a particular company. If this struggling company emerges from bankruptcy and the debt goes from 20 cents on the dollar to 80 cents on the dollar, the hedge fund will earn 300% return on investment and a 3% return on its total capital.
The perspective of the individual investor
The same attributes that attract hedge funds also attract individual investors to distressed debt. While an individual investor is unlikely to take an active role in advising a company in the same way as a hedge fund, there are nevertheless many ways for a regular investor to invest in distressed debt. .
The first hurdle is finding and identifying troubled debts. If the company is bankrupt, the fact will be in the news, company announcements and other media. If the company hasn’t filed for bankruptcy yet, you can infer how close it might be by using bond ratings like Standard & Poor’s or Moody’s.
After identifying the distressed debt, the individual will need to be able to purchase the debt. Using the bond market, as some hedge funds do, is an option. Another option is exchange-traded debt, which has smaller denominations like $25 and $50 instead of the $1,000 denominations bonds are typically pegged to.
These lower face value investments allow for smaller positions to be taken, making distressed debt investments more accessible to individual investors.
Risks for the Individual Investor
The risks for individuals are considerably higher than those of hedge funds. Multiple investments in distressed debt likely make up a much larger percentage of an individual portfolio than a hedge fund portfolio. This can be offset by exercising more discretion in security selection, such as accepting higher-rated distressed debt securities that may pose less risk of default while offering potentially large returns.
A note on subprime mortgage debt
Many would assume that secured debt wouldn’t get into trouble because of the collateral backing it, but that assumption is incorrect. If the value of the collateral decreases and the debtor also defaults, the price of the bond will drop significantly. Fixed income instruments, such as US mortgage-backed securities subprime mortgage crisis, would be an excellent example.
The world of distressed debt has its ups and downs, but hedge funds and sophisticated individual investors have a lot to gain by taking on the potential risk. By managing these risks, both types of investors can earn great rewards by successfully weathering tough times in a business.