Distressed debt

Author: The Carta Team
Read time: 3 minutes
Published date: August 14, 2025

Learn about the key features of distressed debt, including the main benefits and risks for investors, and how distressed debt funds operate.

What is distressed debt?

Distressed debt refers to the bonds, loans, or other debt instruments issued by companies or entities experiencing severe financial distress, often to the point of default or bankruptcy. These securities typically trade at significant discounts to their face value, reflecting the market’s perception of heightened credit risk and the possibility that the issuer (or borrower) may not be able to meet its debt obligations.

Distressed debt investing has become a specialized area within alternative investments, attracting private equity firms, hedge funds, and asset managers seeking to capitalize on the potential for high returns if a turnaround or recovery occurs.

Features of distressed debt

Distressed debt is characterized by several key features:

• It carries a high level of credit risk, with issuers often rated well below investment grade (such as CCC or lower).
• Debt securities are usually illiquid, meaning they are not frequently traded and can be difficult to buy or sell without affecting the price.
• It typically trades at a fraction of its original value, though the size of that discount depends on when the debt was issued. Debt issued by a healthy company that later falls into distress will trade at a significant discount, while debt originally issued by an already distressed company may not have as large a discount. This offers the potential for outsized gains if the company recovers or successfully restructures.
• Events that cause a company's debt to be reclassified as distressed include missed interest payments, covenant breaches, liquidity crunches, or broader economic downturns.
• Any type of debt can become distressed debt, including senior debt, which has repayment priority in bankruptcy, and subordinated debt, which is riskier but may offer a high yield.

How do distressed debt funds work?

Distressed debt funds are investment vehicles that pool capital to acquire and manage distressed securities. These funds are managed by specialized teams with expertise in credit analysis, restructuring, active risk management, and legal frameworks.

The investment strategy may involve buying distressed debt at deep discounts, participating in reorganization negotiations, or taking control of companies through debt-to-equity conversions.

Distressed debt funds often target high-risk investment opportunities during periods of economic volatility or sector-specific downturns, when the supply of distressed assets increases. They typically use advanced data analytics and scenario modeling to make investment decisions, assess recovery prospects, and manage risk.

Benefits and risks of distressed debt

Distressed debt represents both a challenge and an opportunity for investors.