It’s common for businesses to take on debt. After all, during economic upswings, business loans can be relatively easy to get a hold of. Sadly, it’s also common for businesses to default on those loans. When that happens, it may make sense to invest in business debt.

Before getting into specific strategies, it will be helpful to define some general terms. Once you read the following two sections, you’ll understand the two most common scenarios in which an investor or investment firm buys a company’s debt.

Buying Money Owed

When a business owes money to a lender, that lender can sell the debt to a third party. When another company buys this debt, they gain the right to instigate collection efforts. This new owner of the debt hopes to profit off the interest owed.

Buying a Company That Is in Debt

Most businesses carry some debt at one time or another. If you were to sell your business while carrying debt, you would have three main options:

  • Set a higher price than you otherwise would so you can cover the debt.
  • Negotiate a lower sale price with the stipulation that the new owner assumes the debt.
  • Split the difference by paying some of the debt while transferring the rest to the new owner.

Similarly, if you were buying such a business, you would likely be presented with one of these options.

The Pros and Cons of Buying Debt

One solid benefit of buying debt is that it creates a steady stream of income in the form of interest payments. What’s more, you get to profit from this interest without doing any additional work. The original lender did the hard work of negotiating the rate and of marketing their services to the business in the first place. All you have to do is enforce collection of the payments.

On the other hand, if the business defaults on the loan, your new income stream dries up.

Investing in Business Debt

Distressed debt investing is the practice of investing in companies that owe large amounts of debt. This differs from regular investing as instead of investing in stocks, you’re buying bonds instead. A bond is an in instrument of indebtedness.

As a distressed debt investor, you would seek out companies that are under performing or that are facing bankruptcy. Either of those conditions make it likely that they’re saddled with considerable debt. You would simply buy as many of the bonds as you can. Acquiring all or most of the debt gives you considerable power should the company need to restructure or liquidate. Being the primary creditor means you would have a great deal of say in what happens to the company. In fact, in the event of liquidation, the primary debt holder gets priority over the equity holders.

For instance, in 1987, investor Martin Whitman bought $14-million worth of debt and stock from the struggling firm, Anglo Energy. When things didn’t improve for Anglo Energy, his investment enabled him to take control. He put the company into bankruptcy immediately, and then negotiated settlements with the other creditors. This, in turn, allowed him to return the company to solvency, and he came out well ahead.

Keep in mind, though, that some distressed companies rebound, often by cutting expenses as much as possible. If the company rebounds, and is able to pay off its debt, you would lose any say over the company’s fate. On the other hand, while this is a high-risk investment strategy, it is not correlated with other stock market risks. In other words, when you buy a company’s debt, you’re diversifying your portfolio at the same time.

Buy Into a Weak Company

As mentioned, when considering buying another company’s debt, it is crucial that the company in question is facing bankruptcy or has already declared bankruptcy. One way to identify companies that will soon be forced to declare bankruptcy is to watch for businesses that have taken on more debt than they can handle. Look at any publicly available financial data to determine this. One way you can potentially identify a distressed company is to monitor their bonds for a period of time. If those bonds are trading for well below what you think they’re worth, that can be an indication that the company is in trouble. You can also check M&A activity and credit negotiations.

It’s not terribly easy for individuals or small businesses to get into the distressed debt game. This form of investment often requires millions of dollars in capital. However, there are hedge funds that incorporate distressed debt investing, and you can become involved in that way.