distressed debt market making: how does it work?

High Yield Company X has a full capital structure including secured debt, senior debt, subordinated debt and equity. Bonds are performing credit and trade at par or thereabouts (100). High yield market making desk makes markets in the bonds, allowing investors (hedge funds, mutual funds, insurance companies) to buy and sell portions of the bonds. If the market consensus price for a bond is 105 they may skew their market around the position they’d like to have I.e if they like the credit they’d want to be long and may make a 104.75/105.75 market, if they dislike they may make 104.25/105.25 and they would hope investors have a similar view to allow them to find the other side of the trades.

X gets into financial distress and bonds drop reflecting a high likelihood of not paying out at par value. The market making of this debt then passes to the distressed desk. Analysts on the desk will come up with a view on all the different tiers of debt and equity about what the fair value of them is. The trader (market maker) will then skew his markets around that view and try to build positions which reflect the view of the desk aswell and monetising any 2-way flows. E.g desk thinks a bond is worth 40 trader may make 39/41 market. The desk may also build up smart relative value trades across the cap structure (as a distressed investor would). Sometimes the market may be trading well away from the desks view of fair value but they will still make markets and try and monetise 2 way flows while understanding the risks of getting stuck long or short at levels far away from the FV view. A lot of flows on distressed names would initially be selling from holders who were involved from its performing days with hedge funds and distressed specialists being the main buyers. Clearly these funds can also go both ways though which allows the potential to trade both ways and capture bid/offer.

In short a bank market making desk acts very similarity to a distressed investor and will usually take views on situations but they have another bow in their arsenal in terms of trying to monetise the flows between investors.

n.b FV is rarely a hard number and a multitude of qualitative and quantitative factors go into it. Some traders may trade the sentiment and focus less on theoretical fair values. Some may follow specific large investors they think are smart etc etc.