What is Distressed Securities?
900 reads · Last updated: December 5, 2024
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.
Definition
Distressed securities are financial instruments issued by companies that are near bankruptcy or are already bankrupt. These securities can include common and preferred stocks, bank debt, trade claims, and corporate bonds. If a particular security fails to meet certain covenants (such as maintaining a specific debt-to-equity ratio or credit rating), it can also be considered a distressed security. Due to the issuing company's inability to meet its financial obligations, the value of these financial instruments significantly decreases. However, the inherent risk of distressed securities means they can offer high returns for high-risk investors.
Origin
The concept of distressed securities originated in the 1980s when reforms in U.S. bankruptcy laws made it easier for investors to purchase and trade these securities. As bankruptcy proceedings became more complex, investors began to focus on the potential value of these securities, especially the high returns that could be achieved during company restructuring or liquidation.
Categories and Features
Distressed securities are primarily divided into debt securities and equity securities. Debt securities include bank debt and corporate bonds, typically considered distressed when a company cannot repay its debts. Equity securities include common and preferred stocks, usually considered distressed when a company's financial condition deteriorates. The main features of distressed securities are high risk and high return potential, making them suitable for investors with a high risk tolerance.
Case Studies
A typical case is the Lehman Brothers during the 2008 financial crisis. The bankruptcy of Lehman Brothers led to many of its issued securities becoming distressed, attracting many speculative investors. Another case is during the 2015 Greek debt crisis, where Greek government bonds were considered distressed securities, attracting many investors due to their high risk and potential high returns.
Common Issues
Common issues investors face when investing in distressed securities include misjudging the risk and misunderstanding the company's restructuring process. Investors should carefully assess the company's financial condition and restructuring plans to avoid potential losses. Additionally, the market liquidity of distressed securities is relatively low, which may make it difficult for investors to sell these securities when needed.
