Distressed securities

Distressed securities are securities of companies that are either already in default, under bankruptcy protection, or in distress and heading toward such a condition. The most common distressed securities are bonds and bank debt. While there is no precise definition, fixed income instruments with a Yield to Maturity in excess of 600 basis points over the riskless rate of return (e.g. Treasuries) are commonly thought of as being distressed.

Historically, distressed securities have traded at discounts to a rational assessment of their risk-adjusted value for a number of reasons. For example, banks or institutional investors often have constraints that prevent them from investing in such circumstances. This has led to above average returns (adjusted for risk) from investors in this asset class. In recent years, the amount of capital devoted to the distressed securities sector has increased.

When companies enter a period of financial distress, the original holders often sell the debt or equity securities of the issuer to a new set of buyers. In recent years, private investment partnerships such as hedge funds have been the largest buyers of distressed securities. Other buyers include brokerage firms, mutual funds, and specialized debt funds (such as Collateralized Loan Obligations)are also active buyers. Investors in distressed securities often try to influence the process by which the issuer restructures its debt, narrows its focus, or implements a plan to turnaround its operations. Investors may also invest new money into a distressed company in the form of debt or equity.

The US has the most developed market for distressed securities. The international market (especially in Europe) has become more active in recent years as the amount of leveraged lending increased, capital standards for banks have become more stringent, the accounting treatment of non-performing loans has been standardized, and bankruptcy laws have been modernized.

Investors in distressed securities typically must make an assessment not only of the issuer's ability to improve its operations but also whether the restructuring process (which frequently requires court supervision) might benefit one class of securities more than another.