Distressed Debt

What Is Distressed Debt?

Distressed debt refers to the bonds, loans, or other obligations of companies or sovereigns that are in financial distress — either already in default or trading at yields implying a very high probability of default. The standard market definition is debt trading at 1,000 basis points (10 percentage points) or more above comparable Treasuries, or below 80 cents on the dollar.

Why It Exists

When a company faces distress, its bonds sell off sharply because:

1. Many institutional investors (investment-grade funds, pension funds) are prohibited from holding distressed or defaulted bonds
2. Forced selling creates opportunity for specialist investors who can hold through a restructuring
3. The uncertain recovery timeline and complexity deter most buyers

Distressed Investing Strategies

Fulcrum security investing: Identifying the tranche of debt that will be converted to equity in a restructuring — the "fulcrum" between debt that is paid in full and equity that is wiped out.

DIP lending: Providing Debtor-in-Possession financing to companies already in Chapter 11 bankruptcy — high priority, short duration, high yield.

Claims trading: Buying trade claims or other obligations at a discount to par for eventual recovery in bankruptcy proceedings.

Key Metrics

• Recovery rate: Historically, senior secured debt recovers ~70 cents on the dollar; senior unsecured ~40 cents; subordinated ~25 cents
• Time to resolution: Chapter 11 bankruptcies typically resolve in 1–3 years
• Trading at recovery: When bonds trade close to expected recovery value, the "option value" of the company surviving is priced out

Macro Relevance

Distressed debt volumes are a real-time gauge of credit market stress. When the distressed ratio (% of HY bonds yielding >1000bps over Treasuries) rises above 10%, it signals material systemic risk. The peak during COVID was ~30%; during the GFC it was ~80%.