If your neighbour bought a car last year for £20,000 but offered to sell it to you this week for £4,000, you’d want to have a good look under the bonnet.

A similar principle applies to investing in distressed debt bonds which have seen their prices fall sharply because investors have spotted major problems at the companies that issued them.

You can pick up such bonds trading at bargain prices and therefore often paying generous yields. You could also make big capital returns if the companies backing the bonds recover. In some cases, investors buy fixed- income securities in the hope that the company might implement a debt-for-equity swap in which case their bonds are exchanged for a shareholdingtake in the company.

But if you invest, remember you are taking significant risks and could lose most or all of your money, particularly if the financial strength of the company deteriorates.

Distressed bonds are also an illiquid asset class. One fund management group recounts how one of its distressed debt experts found it so hard to get prices for bonds that she had to flirt on the phone with bankers to get them to provide quotes.

Investors define distressed debt as bonds which are trading below 70p in the £1, ie at below 70 per cent of their redemption value. But bonds which yield more than 10 percentage points above government bonds also fall into the distressed category. In the UK, such bonds would offer running yields of about 14.5 per cent.

Distressed debt has hit the headlines this week because Eurotunnel, the company which runs the Channel tunnel, has been planning to restructure £6.2bn of debt, including its undervalued bonds. Some fund managers have been investing in its fixed-income securities. Hugh Hendry, a hedge fund manager who formerly ran a successful traditional fund, Odey Continental European, has invested in Eurotunnel, though he notes that the capital structure is particularly complex.

Other companies where investors have in the past sought high returns from bonds trading at low prices include Marconi, the telecoms equipment supplier, as well as NTL and Telewest, the cable operators.

Fund managers and consultants agree that returns from investing in distressed bonds can be high if the companies continue to meet their obligations after re-organising their businesses. But some distressed bonds collapse, bringing down average returns for this asset class. Annual returns on distressed bonds have been 6.3 per cent on average, according to an index compiled by New York University which began in 1987.

Another potential advantage of distressed bonds is that investors can seek to reduce the overall risks of their portfolio by investing some money in these assets. This is because distressed debt has not traded closely in line with stock markets.

“The potential returns can be massive…when the company comes up with a rescue plan,” says Roman Gaiser, a bond fund manager at F&C Asset Management.

However, he warns that there are significant risks. “The company may be losing money or it may not have enough cash on its balance sheet,” he says.

Bonds normally trade at low prices because investors have factored in the danger that the companies will fail to pay interest or even fail to repay the capital.

“Either the company comes up with a rescue plan and you get all your money back, or at least a big chunk of it, or there is no rescue and you get no money back,” warns Gaiser.

He says that investors should only consider investing in distressed debt if they can genuinely afford to lose the money. “It shouldn’t flatten your financial security if you lose the money.”

A further risk is the lack of information about the market. Private individuals cannot easily get data about prices and returns and even professional investors suffer similar problems. Hendry does not invest in distressed debt on a significant scale – Eurotunnel is an exception – partly because he cannot get access to charts showing the price trends.

Investors may also need to wait for some time before they see any returns and they need to be willing to convert their bonds into shares after a company reorganises.

Paul Read, who manages £2.2bn-worth of bonds at Invesco Perpetual, a fund manager, says: “You have to be willing to do a debt-for-equity swap. You must be ready to hold paper for a year or two without receiving a coupon. And you need to be prepared to hold the shares for some time.”

Investors who are willing to take the risks should get exposure through funds rather than directly-held bonds, which can be very volatile and complex, say advisers. Gavin Rankin, a director at Citigroup private bank, says: “Distressed debt is highly labour-intensive and a lot of it requires looking at paperwork.” RankinHe has recommended the asset to some clients but only as a very small proportion of their portfolio.

Information about specific funds that back distressed debt is scarce, but advisers to wealthy clients say investors with hedge funds or private equity vehicles should check whether they provide exposure to the asset. The Thames River High Income fund is one of a small number of funds with holdings in distressed bonds – . It has 8.7 per cent of its portfolio. in distressed debt.

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