How to invest in distressed debt

Such allocations can enhance and diversify portfolios and drive returns as the distressed debt opportunity set expands. But there are some key considerations to take into account when allocating to this asset class.

With high double-digit returns in prospect, it is an option that, though not without risk, could well pay off

Firstly, it is helpful to identify common themes observed among most distressed investors. Most will purchase discounted obligations, either on an exchange or through bilateral negotiations with a broker dealer or a creditor. 

The discounted purchases will tend to generate meaningful current yield as well as significant capital gains. In general, distressed debt managers target net returns to investors exceeding 15 per cent. 

Finally, the dispersion of outcomes at the investment level can be very large. These common attributes can make distressed debt managers an appealing choice for pension funds. 

A lack of differentiation can undermine tactical allocation

Despite these similarities, distressed managers should not be lumped together. In fact, they can be differentiated according to the risk they assume and the tenor of the underlying instruments that they purchase. A lack of differentiation can undermine tactical allocation within the broader distressed grouping.

The most common distressed managers are those that seek the 'fulcrum security' – frequently defined as the most senior instrument to be impaired – in an effort to drive a favourable outcome by influencing the restructuring process.

'Option theory' provides insight into this approach. Credit instruments like loans and bonds can be viewed as 'call options' on the equity of a borrower. Option volatility tends to offer greater opportunities to identify mispricing: volatility tends to be highest when options are near expiry. 

We can conclude that the most senior security-facing impairment offers the greatest chance to capitalise on mispricing. For example, think of bankruptcy resolution or out-of-court restructuring finalisation as expiry, and a fulcrum security as the at-the-money option (unimpaired debt is an in-the-money option while completely impaired debt is an out-of-the money option).

These managers play that volatility by influencing the bankruptcy process in order to drive returns. Investments can pay off handsomely if negotiations go as planned. However, they can quickly underperform if other creditors, company management, ownership, or even a local bankruptcy court judge becomes uncooperative – soft power and personalities matter.

Their returns come from the accurate assessment of borrower enterprise value; a creative and co-operative approach to form coalitions, obtain consensus, and craft constructive outcomes; and a thorough understanding of their rights and remedies enshrined in the relevant documentation.

Less common are the distressed-for-control managers, who really seek to gain control of business through the purchase of distressed debt obligations. This often means diluting existing ownership in a restructuring, replacing management and affecting operational or strategic change in order to redirect a struggling business.

These teams can resemble private equity managers in this regard. Their hold period can be similarly long and they frequently take equity-like risk.

Balance risk tolerance with return objectives

Finally, pull-to-par distressed managers neither aspire to own borrowers or to run the risk that attends the pursuit of returns in restructuring.

While they have the capabilities to go these routes if necessary, they prefer to buy debt that is 'money good' at discount with a view to a shorter-term catalyst such as an upcoming maturity. These managers frequently assume refinancing risk.

These different approaches mean that within the distressed debt universe, different managers take short, medium or long-term perspectives, depending on their appetite to seek a quick exit, play the long game or find a middle path. Layering in all three types of managers should help create a balanced sub-portfolio of distressed debt.

Pension funds must balance their risk tolerance with their return objectives and current pay requirements.

Diversifying among different strategies within the distressed debt asset class is worth considering – differentiating between managers can enable investors to allocate constructively through the cycle.

With high double-digit returns in prospect, it is an option that, though not without risk, could well pay off.

Tod Trabocco is managing director and credit specialist at Cambridge Associates