Distressed Securities refer to a corporation’s financial instruments when the underlying companies are nearing or actually undergoing bankruptcy presently. Because such a firm is unable to cover all of its various financial responsibilities, its financial instruments will have undergone a dramatic decline in value. Yet thanks to the implied volatility that comes along with such inherent risk, the instruments actually provide investors with the very real possibilities of enormous returns. Such securities might be comprised of corporate bonds, trade claims, bank debt preferred stock, or common stock shares.
In the challenging investing climate of today, there are often many investors competing for opportunities which are bargain priced that might come with higher risk in the form of such Distressed Securities. There are scenarios where investors will carefully study up on the company plight and determine that it is not actually so serious as the market and public perceive it to be.
Because of this, they believe that their investments bought at a steep discount may increase dramatically in value as the situation of the company’s finances becomes finally resolved. There are other cases where the investors agree with analysts that the firm may fall into bankruptcy. Yet they might be confident at the same time that the liquidation proceeds will be sufficient to cover the value of the securities which they obtain at a drastic discount to face value.
Individual investors should be extremely familiar with what will happen to such Distressed Securities should the company slide into either Chapter 7 or Chapter 11 bankruptcy. With the overwhelming majority of these bankruptcies, the common share equity will be completely wiped out. This means that investing in distressed stocks is highly risky. Yet many of the senior-most debt instruments like bonds, trade claims, and bank debts can provide some amount of payout after liquidation.
This is particularly the case when businesses elect to file a case of Chapter 7 bankruptcy. This halts operations and forces liquidation. The resulting funds will then be collected and dispersed out to the creditors according to their various degrees of seniority. With Chapter 11 bankruptcy, the corporation will restructure and resume its business operations. Assuming that such reorganization becomes a success, the distressed securities in the form of either corporate bonds or company stock could return incredible profit percentages as they stage a massive recovery alongside the company’s improving fortunes and future prospects.
The trick is to understand at what stage such securities become Distressed Securities. Analysts will commonly label them as such when the firm that issues them cannot effectively meet a great number of its financial obligations. In the overwhelming majority of such scenarios, these securities will have been previously downgraded to junk credit rating status, as in CCC or lower by the major credit ratings arms of the debt rating agencies like Moody’s Investor Services or Standard and Poor’s.
Distressed securities are not necessarily always junk bonds though and should not be confused as such. Junk bonds only need to feature a credit rating of BBB or lower in order to be classified as junk. The underlying firm of the bonds is not in bankruptcy nor imminent to go there just because its bond issues carry the junk bond rating and label.
It is worth noting that the expected rate of return for distressed securities will be greater than 1,000 basis points (ten percent) over the rates of return for risk-free assets. This would include U.S. government bonds or Treasury bills’ effective rates of return. It means that when the yield on five-year Treasury bonds amounts to one percent, then the Distressed Securities corporate bond should offer a rate of return of at least 11 percent.