Distressed securities are financial instruments issued by a company that is nearing—or currently undergoing—bankruptcy. These securities can include common and preferred shares, bank debt, trade claims, and corporate bonds.
A particular security can also be considered distressed if it fails to maintain certain covenants—obligations incorporated into the debt or security, such as maintaining a certain asset to liability ratio or a particular credit rating.
As a result of the issuing company’s inability to meet its financial obligations, their financial instruments suffer a substantial reduction in value. However, because of the implicit riskiness of distressed securities, they can offer high-risk investors the potential for significant returns.
Key Takeaways
- Distressed securities are issued by a company that is near to—or in the midst of—bankruptcy.
- The company may also have breached covenants (conditions of the security issuance), often a precursor to bankruptcy itself.
- Certain high-risk investors, sometimes known as ‘hawks’, are willing to invest in distressed securities in the hope of making a quick profit.
Understanding Distressed Securities
Distressed securities often appeal to investors looking for bargains and willing to accept risk. In some cases, investors believe the company’s situation is not as bad as it seems and anticipate their investments will increase in value over time. In other cases, investors may foresee the company going into bankruptcy. However, they feel there might be enough money upon liquidation to cover the securities they have purchased.
Many companies that issue distressed securities end up filing for Chapter 11 or Chapter 7 bankruptcy; thus, individuals interested in investing in these securities need to consider what happens in the event of bankruptcy. In most bankruptcies, equity—such as common shares—becomes worthless, making investing in distressed stocks extremely risky. However, senior debt instruments, like bank debt, trade claims, and bonds, may offer some payout.
Chapter 7 vs. Chapter 11 Bankruptcy
If a company files for Chapter 7 bankruptcy, it will cease operations and go into liquidation. At this point, its funds are distributed to creditors, including bondholders.
In contrast, under Chapter 11 bankruptcy, a company restructures and continues operations. If the reorganization succeeds, its distressed securities, including both stocks and bonds, can yield surprising profits.
Example of a Distressed Security
Securities are labeled as distressed when the company issuing them cannot meet many of its financial obligations. Typically, these securities carry a ‘CCC’ or below credit rating from debt-rating agencies like Standard & Poor’s or Moody’s. Distressed securities can be contrasted with junk bonds, which usually have a credit rating of BBB or lower.
The anticipated rate of return on a distressed security is often more than 1,000 basis points above the rate of return of a so-called risk-free asset, such as a U.S. Treasury bill or Treasury bond. For instance, if the yield on a five-year Treasury bond is 1%, a distressed corporate bond would have a rate of return of 11% or higher, as one basis point equates to 0.01%.
Related Terms: junk bonds, Chapter 11 bankruptcy, Chapter 7 bankruptcy, equity, liquidation.
