US corporations are defaulting on bank loans and bonds at rates not seen since the 1991 recession. During the first nine months of 2002, roughly $480 billion¹ of debt defaulted or became distressed (that is, at serious risk of defaulting), and a McKinsey study estimates that at least an additional $410 billion will suffer a similar fate over the next nine months (Exhibit 1). This problem has a flip side, however. Investing in distressed debt,² either directly or, more likely, through specialized funds, has in years past given investors returns in the mid-teens, with little correlation to equity market returns. Institutional investors, long wary of the distressed-debt market, are now showing more interest in it, given its unprecedented size and the recent poor returns for equities. But they should choose their investments with caution. In this downturn, average recovery rates from distressed debt are likely to be much lower than they were last time.

The distressed-debt market has ballooned because record amounts of credit were extended to noninvestment-grade borrowers in the late 1990s. As lenders relaxed their usual standards for underwriting credit, high-yield bond issues and syndicated bank loans shot up, peaking at $145 billion (in 1998) and...