Distressed Securities

Distressed securities are financial instruments issued by companies that are near or in bankruptcy. They include common and preferred equity, corporate bonds, bank debt, and trade claims. Distress can also arise when a company breaches covenants attached to its debt or other securities, signaling deteriorating creditworthiness and sharply reduced market value.

Key takeaways

• Distressed securities are issued by companies facing severe financial stress or bankruptcy.
• They offer the potential for high returns but carry significant risk, complexity, and illiquidity.
• In bankruptcy, equity typically ranks last and is often wiped out; senior debt and claims have higher recovery priority.
• These securities are frequently rated very low by credit agencies (e.g., CCC or below) and may trade at yields far above risk-free assets.

Why a security becomes distressed

A security becomes distressed when the issuer cannot meet financial obligations or violates debt covenants (such as maintaining certain leverage ratios or credit ratings). Market perception of future losses, cash-flow shortfalls, or impending bankruptcy causes prices to fall and yields to spike.

Types of distressed instruments

• Common and preferred stock
• Senior and subordinated corporate bonds
• Bank loans and trade claims
• Other creditor claims arising in restructuring or liquidation

Bankruptcy outcomes and seniority

How a distressed security performs depends largely on the bankruptcy process and the holder’s position in the capital structure:
* Chapter 7 (liquidation): Operations cease and assets are sold. Proceeds are distributed to creditors according to priority—secured creditors first, unsecured creditors next, equity last. Equity is often worthless.
* Chapter 11 (reorganization): The company restructures and may continue operating. Creditors and shareholders can receive new securities or cash per the reorganization plan; successful restructurings can produce substantial gains for some distressed holders.

Senior debt and secured claims generally recover more than subordinated debt or equity, but actual recovery depends on asset values, legal costs, and negotiated settlements.

Pricing and return expectations

Distressed securities carry much higher yields than risk-free assets to compensate for default and recovery risk. It’s common for distressed corporate bonds to price with spreads of 1,000 basis points (10 percentage points) or more above Treasuries, though actual spreads vary by situation and market conditions.

Who invests and why

Investors in distressed securities include specialist hedge funds, private credit firms, turnaround investors, and other opportunistic buyers. Motivations include:
* Buying undervalued claims before a successful restructuring
* Capturing high yields if default is avoided
* Gaining control or influence in a restructuring process
* Realizing liquidation recoveries that exceed the purchase price

Risks and considerations

• Credit and default risk: issuer may default or leave little recoverable value.
• Legal and restructuring complexity: outcomes depend on court processes and negotiations.
• Liquidity risk: secondary markets can be thin; positions may be hard to sell.
• Valuation uncertainty: asset values, claims priorities, and potential recoveries are often unclear.
• Time horizon: restructurings can take months or years to resolve.
• Costs: legal, advisory, and monitoring costs can reduce returns.

Practical checklist for investors

• Identify the security’s seniority and collateral (secured vs. unsecured).
• Review covenants, upcoming maturities, and default triggers.
• Assess the issuer’s cash flows, asset values, and liquidation prospects.
• Estimate recovery scenarios and implied yields versus risk-free alternatives.
• Consider legal complexities and likely timeline for resolution.
• Decide whether to invest directly or via specialist funds with restructuring expertise.

Conclusion

Distressed securities present high-risk, high-reward opportunities for investors who can evaluate credit structures, legal processes, and recovery prospects. They are generally better suited to experienced or institutional investors; others should consider specialized funds or advisors before participating.