Definition of Distressed Debt

A company's securities that are either under bankruptcy or nearing it are distressed debt. While the term "distressed debt" sounds pretty negative--and the current debtors surely see it that way--there are investors that find distressed debt appealing.

Debt Becoming Distressed

Investment consulting firm Barclay Hedge explains that debt is considered distressed when "its yield to maturity ... is more than 1000 basis points above the risk-free rate of return." That is, if its interest rate is expected to return 10% more to the creditor than a theoretical rate of return with zero risk. Debt might also be considered distressed if one of the major debt-rating agencies such as Standard & Poor consider the debt vulnerable to default.

Opportunities of Investing

The appeal in investing in distressed debt is that the debt is likely sold off at a reduced price, and that the company in debt may not be in quite as bad shape as the market believes. An investor in distressed debt can profit if the company can pay off its debts after liquidation, is successfully reorganized, or if it manages to avoid bankruptcy. These are all cases, Barclay Hedge explains, in which the value of the distressed debt rises.

Risks

While the rewards may be great, investing in distressed debt is as risky as it sounds. Some securities, such as the company's common stock, may be rendered worthless under a bankruptcy, and if the company the debt is bought from doesn't improve its operations, the value of the securities bought isn't going to increase and won't yield any returns.

"Vulture Investors"

Because of the high risk involved, most investors in distressed debt tend to be large institutions such as hedge funds and investment banks, according to Barclay Hedge. Investment news site Fund Strategy concurs and notes that distressed debt investors are often coined "vulture investors" for trying to profit off struggling businesses.

Ideal Assets in Distress

Fund Strategy explains that most investors in distressed debt focus on buying bonds as "bondholders have prior claims on a company's assets compared with shareholders." An investor in distressed debt must make a careful look at not only the debtor company's prospects, but also the assets that can survive liquidation and yield a profit.