What Are Distressed Securities?
Distressed securities arefinancial instrumentsissued by a company that is near to—or currently going through—bankruptcy. Distressed securities can include common and preferred shares, bank debt, trade claims, andcorporate 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 the ability to maintain 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 high returns.
Key Takeaways
- Distressed securities are securities 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), which is frequently a precursor to the bankruptcy itself.
- Certain high-risk investors, sometimes known as ‘hawks’, are willing to invest in distressed securities in the hope of making a quick buck.
Understanding Distressed Securities
Distressed securities often appeal to investors who are looking for a bargain and are willing to accept risk. In some cases, these investors believe the company's situation is not as bad as it looks, and as a result, they anticipate their investmentswill increase in value over time. In other cases, investors may foresee the company going into bankruptcy. However, they feel confident that there might be enough money upon liquidation to cover the securities they have purchased.
In many cases, the companies that issue distressed securities end up filing forChapter 11or Chapter 7 bankruptcy; as a result, individuals interested ininvestingin these securities need to consider what happens in the case of bankruptcy. In most bankruptcies,equity—such as common shares—is rendered worthless. This makes investing in distressed stocks extremely risky. However, senior debt instruments, such as bank debt, trade claims, and bonds, may yield some payout.
In particular, if a business files Chapter 7 bankruptcy it will stop operations and go intoliquidation. At this point, its funds are dispensed to its creditors, including bondholders.
Conversely, under Chapter 11 bankruptcy, a business restructures and continues operations. If reorganization is successful, its distressed securities, including both stocks and bonds, may yield surprising amounts of profits.
Example of a Distressed Security
Securities are labeled as distressed when the company issuing them is unable to meet many of its financial obligations. In most cases, these securities carry a "CCC" or below credit rating from debt-rating agencies, such as Standard and Poor's or Moody's Investor Services. Distressed securities can be contrasted with junk bonds, which traditionally have a credit rating of BBB or lower.
Typically, the anticipated rate of return on a distressed security is 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 example, if the yield on a five-year Treasury bond is 1%, a distressed corporate bond has a rate of return of 11% or higher, based on the fact that one basis point equates to 0.01%.
FAQs
Example of a Distressed Security
What are distressed securities also known as? ›
Distressed securities are securities over companies or government entities that are experiencing financial or operational distress, default, or are under bankruptcy. As far as debt securities, this is called distressed debt.
What is an example of a distressed asset? ›
A distressed asset could be personal property, real property, or equity ownership in a business. An owner might sell a distressed asset because of bankruptcy, foreclosure, or other financial calamity.
What is an example of a distressed credit? ›
The most common distressed debt securities are bank debt, bonds, trade claims, and common and preferred shares.
What is a distressed security strategy? ›
Summary. Distressed securities are securities of a company under financial distress – typically companies that are in or near bankruptcy. Distressed securities exist when a company sees its bond rating downgraded by rating agencies to a CCC bond rating or below.
What are examples of distressed securities? ›
Distressed securities can include common and preferred shares, bank debt, trade claims, and corporate bonds.
What are the 4 major categories of securities? ›
There are four main types of security: debt securities, equity securities, derivative securities, and hybrid securities, which are a combination of debt and equity.
How would you explain distress? ›
Emotional, social, spiritual, or physical pain or suffering that may cause a person to feel sad, afraid, depressed, anxious, or lonely. People in distress may also feel that they are not able to manage or cope with changes caused by normal life activities or by having a disease, such as cancer.
What is another name for a distressed property? ›
Synonyms: abandoned property (buildings, lots, real estate), distressed property (buildings, real estate), vacant property (buildings, lots, real estate) Broader: blight, urban decay.
Which of the following would be considered a distressed property? ›
A distressed property is a home that's on the brink of foreclosure or is already owned by a bank or has been repossessed by the mortgage lender.
The major players in the distressed debt market are hedge funds and private equity firms, which typically have large amounts of capital to invest in distressed companies.
How does distressed investing work? ›
Distressed Debt Investing refers to the purchase of debt at a discount from existing lenders, where the borrower is insolvent or in distress. The objective of distressed debt investing is to identify debt securities trading at a larger discount than is justified given the potential for a turnaround.
What is the meaning of distressed in finance? ›
Financial distress is a condition in which a company or individual cannot generate sufficient revenues or income, making it unable to meet or pay its financial obligations. This is generally due to high fixed costs, a large degree of illiquid assets, or revenues sensitive to economic downturns.
What is a distressed asset? ›
When the person or business needs immediate cash and wants to sell the asset at less than its value, it becomes a distressed asset. Distressed assets fall into three basic categories: personal property, equity ownership in a business (which is a form of personal property), and real property.
What makes a bond distressed? ›
Bonds tend to be classified as distressed bonds if they're either in default or at high risk of going into default. Now very often such bonds are also characterized by low credit rating, depressed bond prices, and also very often liquidity, which is very shallow.
What counts as distressed debt? ›
Distressed debt is the debt from entities that are going through bankruptcy—or are on the brink of going through it. Stressed debt is the debt from entities with serious financial issues, but not serious enough that they are immediately near bankruptcy.
What is another name for debt securities? ›
Bonds, such as government bonds, corporate bonds, municipal bonds, collateralized bonds, and zero-coupon bonds, are common types of debt securities.
What are the three main types of securities? ›
There are primarily three types of securities: equity—which provides ownership rights to holders; debt—essentially loans repaid with periodic payments; and hybrids—which combine aspects of debt and equity. Public sales of securities are regulated by the SEC.
What is also known as debt securities? ›
Debt securities, such as bonds, are designed to reward investors with interest and the repayment of capital at maturity. The repayment of capital depends on the ability of the issuer to meet their promises – failure to do so will lead to consequences for the issuer.
What is the securities market also known as? ›
Stock exchange is known as the market for securities.
