Understanding Distressed Securities: Risks, Opportunities, and Examples

What Are Distressed Securities?

Distressed securities are financial instruments issued by a company that is near to—or currently going through—bankruptcy. Distressed 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 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.

How Distressed Securities Fit into Investment Strategies

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 investments will 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 for Chapter 11 or Chapter 7 bankruptcy; as a result, individuals interested in investing in 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 into liquidation. 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.

Distressed Security Characteristics and Example

Securities are called distressed when the issuing company can’t meet its financial obligations. Typically, these securities have a “CCC” or lower credit rating from agencies like Standard & Poor’s or Moody’s. Distressed securities differ from junk bonds, which usually have a BBB or lower rating.

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%.

The Bottom Line

Distressed securities are associated with companies facing bankruptcy. While distressed securities can offer high returns, they carry inherent risks due to the issuing company’s financial instability. Types include common and preferred shares, bank debt, trade claims, and corporate bonds.

These might interest high-risk investors, but there are numerous factors to consider, from bankruptcy proceedings to the treatment of equity and senior debt instruments under different bankruptcy chapters. Investing in distressed securities requires a careful consideration of their risks and potential rewards, especially in light of their credit ratings and anticipated rate of return relative to risk-free assets.

It’s important to understand the implications of bankruptcy scenarios, including the difference between liquidating assets under Chapter 7 and restructuring under Chapter 11.