What are Distressed Securities?

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.

What Happens to Distressed Securities in Bankruptcy Cases?

Usually, distressed securities are issued by companies going into bankruptcy or under intense financial pressure. In most cases, such companies eventually file for Chapter 7 or Chapter 11 of the bankruptcy code. Investors are generally advised to consider investing in such securities given that they become worthless due to bankruptcy.

Investing in distressed securities entails a high level of risk and investors are warned against such. In some, cases, investors purchase distressed securities despite knowing that a company is going into bankruptcy. This is when the foresee that once the company is liquidated, there will be enough money to settle all the securities held by investors.

When Are Securities Considered Distressed?

Generally, securities such as corporate bonds, common and preferred shares, bank debt, and trade claims are Distressed when the company issuing them is under intense financial pressure and is unable to meet its obligations. Distressed securities are common with companies that are going into bankruptcy or insolvent.

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A typical distressed security has a below credit rating or CCC assigned to it by rating agencies. This is due to the fact that these securities have high risks and have suffered a significant reduction in their intrinsic value.

Distressed Security Example

Based on the rating systems from rating agencies, such as Moody’s Investors Service (Moody’s) and Standard & Poor’s (S&P), firms use a rate ranging from AAA to D. Ratings above BBB are considered investment grade, while BB and below are considered non-investment grade. For distressed securities, anything rated CCC or below is often considered distressed.

Another accepted definition for distressed securities exists. Securities are classified as distressed when trading with a yield to maturity of greater than 1,000 basis points, or otherwise 10% above the risk-free rate of return. Yield to maturity is the anticipated rate of return of a bond if it is held to maturity.