During the pandemic, there was uncertainty and confusion in equal measures. As we know, markets fear uncertainty the most; they can recalibrate and re-evaluate any bad news, but uncertainty tends to bring out the greatest fears of investors. This impacts not only equity prices but also corporate bonds and distressed debt, which can often be oversold and mispriced.

 

Consequently, for those who are willing to do their research and take an element of risk, there may be some mileage in considering distressed debt and credit market arbitrage situations.

 

Understanding distressed debt

 

Distressed debt tends to be debt or credit instruments that trade between 50 and 60 cents on the dollar. While not necessarily at the end of their functional life, when a company's debt is trading around this level, it does suggest serious problems. We saw many instances of companies slipping into distressed debt status during the pandemic, although emergency funding made available by governments and central banks did help some companies recover.

 

When it comes to making a profit from distressed debt, this tends to come by two different routes:-

 

· Restructuring of the company where new debt terms are negotiated

· Liquidation whereby assets are sold off, and net funds returned to creditors

 

As you can see, there are obvious risks associated with investing in distressed debt, but there are also significant opportunities, especially when markets overreact.

 

How does credit market arbitrage work?

 

In theory, credit market arbitrage is relatively simple, but there is much work to do to identify value-for-money positions. Some of the factors to consider include:-

 

Capital structure arbitrage

 

This is a means of benefiting from the price differential between senior and junior debt for the same company, which is experiencing difficulties. It is possible to take advantage of these pricing anomalies, wait until a degree of calm returns, and then profit.

 

Pair trading

 

If you think a company has the potential to recover but are not totally convinced, it may be interesting to consider pair trading. This involves taking a short position on the equity, which is likely to be the first to suffer in the event of further difficulties while taking a long position on the distressed debt.

 

Balancing the risks and potential rewards

 

Stock or bond prices rarely fall in a straight line; instead, they are often subject to knee-jerk reactions, partial recoveries, further falls, etc. If you do identify a pricing anomaly, even if it goes your way, you may experience illiquidity, and what seemed like a relatively simple liquidation of company assets can drag on for many years. This not only delays the crystallisation of the potential profit, but it also means that your funds are committed indefinitely.

 

On the flip side, no matter the potential, once a company is in a downward spiral, things can quickly go from bad to worse. You could lose all of your money!

 

Did you know that Apple nearly went bankrupt?

 

Just look at Apple today, valued in excess of $3 trillion and one of the largest companies in the world. However, if we cast our minds back to the early days, 1997 to be precise, the company was literally on the verge of filing for Chapter 11 bankruptcy protection in the US. While not necessarily an example of distressed debt, more a distressed equity price, the company was rescued by none other than Microsoft, which invested $150 million into the company in exchange for 18 million shares.

 

There is no official record of the value of Apple's distressed debt at the time, but on the verge of bankruptcy, we can imagine it was some way from par value. Amid the doom and gloom, those who believed in the company would be richly rewarded, although nobody could forecast how the company would develop in the years since.

 

Conclusion

 

History shows that equity and bond prices can overreact in the short term, on the upside and the downside, creating potential trading opportunities. The added danger of investing in distressed debt is simply the potential that the company may well go out of business. Alternatively, a sharp turnaround, healthy disposal of net assets, or a restructuring of debt could lead to a significant gain for those willing to take the risk.

 

As with any investment, particularly when looking to acquire distressed debt, it's important to take guidance from your financial adviser.

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