How to See Opportunity in Distressed Debt
Warren Buffett once famously said, “Cash combined with courage in a time of crisis is priceless.” This notion is true when it comes to distressed debt investing. It requires investors to look at opportunities that emerge when there is a crisis, and second, to have the courage to act during times of uncertainty.
The economic downturn that has resulted from the coronavirus pandemic is likely to have farther-reaching effects than initially thought and will probably take us time to fully recover. At times like this, it’s important to understand that even though things aren’t the way they used to be, individual investors can still find opportunities in new asset classes.
What is distressed debt investing?
Distressed debt investing is the purchase of corporate debt: including bank loans, investment-grade bonds, and high-yield bonds, at a discount. Bonds and other debt instruments may trade at, above or below par (meaning at their face value or the original price at which they were issued). Typically, debt is issued at par, or 100 cents on the dollar. However, when a company is faltering or an industry is struggling, it may cause the debt to trade down and, by definition, the yield of the coupon on that debt trades up. Let me explain exactly what that means.
For example, a bond was issued at par—at 100 cents on the dollar—and had a 6% coupon rate, which is the interest rate paid annually. In the event that the company issuing the bond gets in trouble, the bonds may trade down to 80 cents, yielding 7.5%. So, as the price of the bond trades down, the effective yield goes up, in this case, from 6% to 7.5%.
Bonds that trade at more than 10% yield are generally considered distressed debt. Debt is paid back before any equity investors are paid, which creates interesting opportunities.
How does distressed debt investing work?
Distressed debt investing is typically conducted only in the institutional markets. Generally, individual investors (also known as retail investors) can’t get access to distressed debt investing because of how the financial industry is structured. This is largely because banks and trading desks have typically catered to large institutional investors, such as hedge funds, that focus specifically on this market.
In past cycles, retail investors have been net sellers of assets, meaning they typically sell during times of uncertainty. They don’t have the stomach to buy debt during downturns in the economy. Retail investors tend to follow their behavioral instincts, which typically dictate that they are more likely to sell rather than risk purchasing more. However, those might be the times in which excellent risk-reward opportunities exist.
How can individual investors take part in distressed debt opportunities?
It can be difficult for retail investors to take part in distressed debt opportunities. One way, however, is to invest in high yield bonds through a leveraged loan vehicle or high-yield index bond product. High-yield bonds are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds.
Another way would be to invest in downtrodden public equity deals. However, these strategies carry significant risks. Investors should work with an investment manager that has experience in navigating the world of distressed investing, as there are significant obstacles to accessing these opportunities.
It’s important for distressed debt investment managers to have experience in the world of restructurings, Chapter 11 bankruptcies, and negotiating with financial advisors, legal advisors and companies, in order to achieve positive outcomes for investors.
What makes a distressed asset attractive to institutional investors?
During a recession or during a period of high volatility, there may be a significant number of sellers in the marketplace that overwhelm the number of buyers. This kind of scenario can lead to distressed investing opportunities. This can also cause the pricing of assets to trade significantly below their intrinsic value. In a market environment where non-economic and fear-stricken sellers abound, it can be an attractive time to purchase assets. Value investors who buy assets at below market value may achieve a healthy return when the market recovers.
Warren Buffett popularized this investment strategy and has achieved market beating returns over the course of his career.
Under what circumstances should investors consider investing in distressed opportunities?
Investors should consider investing in distressed opportunities if they have knowledge and experience in this area or are working with an experienced investment manager. Just because a stock trades down, doesn't mean that it will trade back up. Many friends and clients asked me over the past few weeks if energy stocks or bonds were an interesting buy when oil prices were at $30. I advised them that the supply/demand was out of favor and that oil prices could trade down below $10 a barrel. For a brief period of time, near term oil prices traded even lower than that, below $0, meaning you have to pay someone to take a barrel of oil off of your hands because storage costs had increased.
During times of distress, individual security selection is critical. It is important to identify a seasoned investment advisor who can navigate the difficult waters of distressed investing in order to achieve outsized investor returns.
How might distressed debt be right for investors in the current circumstances?
Distressed debt may be an attractive investment area for investors who are motivated to explore alternative investments. Given the current pandemic, there are many industries that are significantly distressed, including automotive, lodging, airlines, restaurants, casinos, and nearly all consumer-related services.
Many of these industries will have a difficult time recovering from the current crisis and investing in them at this point can be extremely risky. As many of these were critical to the economy prior to the coronavirus outbreak, some parts of these industries will recover sooner than others and may turn out to be excellent investment opportunities.
Many elements of distressed debt investing have not been available to retail investors in the past, but identifying specific deals that are less impacted by the current crisis or finding companies that can navigate through this difficult time may prove to be a successful investment strategy. With the right guidance and discipline, this asset class may provide an alternative for individuals to diversify their portfolios.
Daniel Posner is a Senior Advisor to Yieldstreet and is Chief Investment Officer at Rensop Investment Group. He has a wealth of professional experience in financial investing as he headed special situations and distressed investing groups at DE Shaw, Golub Capital and AllianceBernstein.
Mr. Posner graduated from Yeshiva University and received his MBA from the University of Chicago. He is currently a Professor of Finance at the Syms School of Business in New York where he teaches a course on Alternative Investing - Hedge Funds and Private Equity.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.