What Are Distressed Securities?
Let me explain distressed securities directly: these are financial instruments from companies that are either on the brink of bankruptcy or already navigating through it. They include things like common and preferred shares, bank debt, trade claims, and corporate bonds.
A security might also qualify as distressed if the company fails to uphold certain covenants—those are the built-in obligations, such as keeping a specific asset-to-liability ratio or maintaining a particular credit rating.
Because the issuing company can't meet its financial duties, these instruments plummet in value. But here's where it gets interesting for you as a potential investor: the inherent risks mean distressed securities can provide high returns if you're willing to take on that high-risk profile.
Key Takeaways
- Distressed securities come from companies near or in the midst of bankruptcy.
- The company might have breached covenants, which often signals impending bankruptcy.
- High-risk investors, sometimes called 'hawks,' target these for the chance of quick profits.
Understanding Distressed Securities
If you're considering distressed securities, know that they attract investors hunting for bargains who are okay with the risks involved. Sometimes, you might think the company's troubles aren't as dire as they seem, so you expect your investment to grow in value over time.
In other scenarios, you could anticipate bankruptcy but believe liquidation will generate enough funds to cover what you've bought. Often, these companies do file for Chapter 11 or Chapter 7 bankruptcy, so you need to understand the implications.
In most bankruptcies, equity like common shares becomes worthless, making distressed stock investments extremely risky. However, senior debt such as bank debt, trade claims, and bonds might still see some recovery.
Specifically, under Chapter 7, the business halts operations and liquidates, distributing funds to creditors including bondholders. On the other hand, Chapter 11 involves restructuring while continuing operations, and if it works, your distressed securities—stocks or bonds—could deliver impressive profits.
Example of a Distressed Security
Securities turn distressed when the issuing company can't fulfill many financial obligations. Typically, they get a 'CCC' or lower rating from agencies like Standard & Poor's or Moody's. Compare that to junk bonds, which usually rate BBB or below.
You should note that the expected return on a distressed security exceeds 1,000 basis points above a risk-free asset like a U.S. Treasury bill or bond. For instance, if a five-year Treasury yields 1%, a distressed corporate bond might return 11% or more, since one basis point is 0.01%.
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