Distressed debt

A claim becomes distressed when the market stops pricing it on yield and starts pricing it on recovery. The question is no longer what return the coupon offers, it is how many cents of the euro this claim will eventually be worth. Once that switch happens the buyers change too, because the analysis required is a restructuring analysis rather than a credit analysis.

The sellers are frequently not selling on a view. Banks sell to avoid a multi year workout absorbing their people. Funds sell because their mandates prohibit paper below a rating threshold. Collateralised loan obligations sell because their documents cap exposure to the lowest rated assets and usually prohibit holding equity at all, which makes them forced sellers of the very claims about to be converted into shares.

Buyers run one of two strategies. Trading the discount means buying at a price below expected recovery and selling once the outcome is clearer, with no interest in control. Loan to own means buying the layer that will convert into the equity of the reorganised company, which is a control strategy carried out through a credit purchase.

The consequence for anyone negotiating is that cost basis, not face value, drives behaviour. A holder that paid 40 for a claim of 100 is deciding whether to take a profit, while an original lender holding the identical claim at par is deciding whether to accept a loss, and the two will not vote the same way on the same proposal.