If a company declares bankruptcy, then the court will determine the creditor’s priority. The company needs to pay these creditors back based on the preference. Among the first people to be paid are those into distressed debt. The distressed debt investors get paid before employees and shareholders of the company. The creditors might end up taking the ownership of the company, and if this happens, then the distressed debt investors could get cash in case the company turns around.
The risk with purchasing any form of debt is that the borrower could default on payment. It is why most debt investors will study the creditworthiness of the borrowers and then determine if there is a possibility that they will get back their money. The default risk is why the less creditworthy organizations will generate a high return for the investors.
When invested in distressed debt, there is a risk that the company goes bankrupt, and the investor gets left with nothing. It is why those who invest in a distressed debt do a thorough analysis of the risk using test scenarios and advanced models. The hedge funds also spread their risk by entering into a partnership with other firms so that they are not overexposed to risk.
The hedge funds are companies that are privately owned. It pools the investors’ money and invests it into complicated instruments. The main aim of the hedge fund is to take risks and outperform the market.
The hedge fund managers understand and use the method of diversification. A hedge fund would not expose its full portfolio to distressed debt. Learn More on how a hedge fund invests in Bitcoin. The cryptocurrencies are very volatile and you thus need to do proper risk management when you invest in this instrument.
Average investor and the distressed debt
The average retail investor will not get involved in distressed debt. Most of the retail investors restrict their investments to stocks and bonds because distressed debt is far too risky for them. However, the retail investor can explore this field also if they want to.
Some companies let you invest in distressed debt through mutual funds or include the distressed debt in the portfolio.
If you are a retail investor, then you should understand what possibility the distressed debt has to offer. However, a retirement portfolio should stay away from distressed debt. The better option for an average investor would be to stick to equities, secure bonds, and mutual funds which would help to create wealth.