Distressed Securities: Understanding, Risks, and Returns

Distressed securities serve as a financial lifeline for companies on the brink of bankruptcy. Comprising common and preferred shares, bank debt, trade claims, and corporate bonds, these instruments become distressed due to the issuing company’s inability to meet financial obligations or breaches of specific covenants.

Investors attracted to distressed securities often perceive an opportunity for bargains. Some believe the company’s situation might be less dire than it appears, anticipating the potential appreciation of their investments. Others, aware of impending bankruptcy, place confidence in the proceeds from liquidation to cover their acquired securities.

Considering the high risk involved, it’s crucial to acknowledge the potential outcomes of investing in distressed securities, particularly when the issuing company files for Chapter 11 or Chapter 7 bankruptcy. Chapter 7 involves liquidation, rendering equity, such as common shares, worthless. However, Chapter 11 allows for business restructuring, presenting an opportunity for surprising profits on distressed securities, including both stocks and bonds.

Distressed securities often carry a credit rating of “CCC” or below, distinguishing them from junk bonds with a credit rating of BBB or lower. The anticipated rate of return on distressed securities is notably higher than that of risk-free assets, exceeding 1,000 basis points above the rate of return of a U.S. Treasury bill or Treasury bond.

For instance, if a five-year Treasury bond yields 1%, a distressed corporate bond could offer a rate of return of 11% or higher. This substantial potential return reflects the heightened risk associated with distressed securities.

Covenants, conditions incorporated into the debt or security, play a significant role in determining distressed securities. Breaches of these covenants, such as failure to maintain a specified asset to liability ratio or credit rating, contribute to a security being labeled as distressed.

In Chapter 7 bankruptcy, a business ceases operations and undergoes liquidation. Distressed securities, particularly equity like common shares, are typically rendered worthless. Creditors, including bondholders, receive distributions from the liquidated funds.

Chapter 11 bankruptcy involves business restructuring while operations continue. If the reorganization is successful, distressed securities, both stocks and bonds, may yield unexpected profits. This contrasts with Chapter 7, offering investors a chance at recovery.