The Distressed Debt Cycle
Investors buy debt securities because they expect to be paid interest periodically and have their principal repaid when the debt matures.
However, for distressed debt, the consensus is that this debt may not be repaid. The motivation behind purchasing the debt is then to have a “creditor claim” against the debtor: when the company declares bankruptcy, they gain ownership of the company, depending on the debt held. A distressed debt investor tries to figure out what a bankrupt company is worth, how this value will be divided amongst creditors, and how long this process will take.
Opportunities to make returns here are created by the unwise extension of credit. Here’s an example with bonds:
- Stringent standards are applied to bonds
- This facilitates the servicing of debt, making defaulting scarce
- Having a combination of high yields and low risk makes bonds attractive, attracting capital to the bond market
- Increased capital translates to increased demand, resulting in increased bond issuance
- Larger amounts of bond issued leads to lowering of standards
Influences from other cycles include: