Distressed securities

What Is Distressed Securities?

Distressed securities are financial instruments, such as bonds or loans, issued by companies or government entities that are experiencing severe financial or operational difficulties, are in default, or are under bankruptcy proceedings. These securities trade at a significant discount to their face value due to the elevated credit risk associated with the issuer's inability to meet its obligations. Investing in distressed securities falls under the broader category of investment strategy, often considered a specialized segment within fixed income and alternative investments.

History and Origin

The market for distressed securities gained prominence in the 1980s and early 1990s, catalyzed by an increase in the number of large public companies facing financial distress. Initially, the distressed credit market primarily focused on U.S. "junk" bonds before diversifying to include bank debt, real estate loans, and under-priced non-U.S. securities.¹⁴ Key figures like Edward Altman contributed to the analytical framework for predicting bankruptcy, while investors, including pioneers such as Bruce Karsh (co-founder of Oaktree Capital Management), began to formalize the practice of distressed investing.,¹³ This niche, specialized skill set emerged as a mainstream asset class around 40 years ago, signaling inefficiencies in the pricing of securities across the credit and fixed income spectrum.¹² The evolution of distressed investing continued significantly after the 2008-09 Global Financial Crisis (GFC), as banks retrenched from credit markets, leading to hedge funds and private equity firms stepping in as providers of direct lending and structured credit.¹¹

Key Takeaways

• Distressed securities are debt or equity instruments of financially troubled entities, trading at deep discounts.
• The primary objective for investors is to profit from the company's restructuring or eventual recovery, or by gaining control of the entity.
• This investment strategy carries substantial risks, including the potential for total loss of principal if the entity undergoes liquidation.
• Investors often need significant resources and expertise in financial analysis, legal proceedings, and negotiation.
• The market for distressed securities is counter-cyclical, with opportunities often increasing during economic downturns or periods of higher corporate defaults.

Formula and Calculation

While there isn't a universal "formula" for valuing distressed securities in a simple algebraic sense, the core calculation revolves around estimating the potential recovery value of the security relative to its current market price. This often involves a deep analysis of the issuer's assets, liabilities, and potential for reorganization.

A simplified way to think about the potential return for a distressed debt investor might be:

Where:

• Estimated Recovery Value is the projected value an investor expects to receive from the security after a restructuring or bankruptcy process. This requires extensive valuation of the underlying assets.
• Purchase Price is the price at which the distressed security is acquired.
• Accrued Interest refers to any interest payments received or anticipated on the debt during the holding period.

This estimation often involves complex financial modeling and a thorough understanding of the issuer's capital structure and the legal framework of bankruptcy.

Interpreting the Distressed Securities

Interpreting distressed securities involves a rigorous assessment of the issuer's financial health and the likelihood of a successful turnaround or advantageous restructuring. A security is generally considered distressed when it trades at a significant discount to its par value, typically indicating that the market perceives a high probability of default. For debt instruments, this often means trading at 70 cents on the dollar or less, reflecting the market's expectation of a haircut to principal or a lengthy recovery process.

Investors in distressed securities must evaluate the issuer's asset quality, cash flow generation, debt covenants, and the position of their specific security within the capital structure. A deeper discount often implies higher perceived risk but also potentially higher returns if the situation resolves favorably. Understanding the dynamics of the credit cycle and broader economic conditions is also crucial, as these can influence the overall volume and success rates of distressed opportunities.

Hypothetical Example

Consider a hypothetical company, "Alpha Corp," which has issued $100 million in bonds with a par value of $1,000 per bond. Due to severe operational difficulties and mounting losses, Alpha Corp announces it may miss its next interest payment, causing its bonds to trade down sharply in the market. An investor, "Distress Capital," believes Alpha Corp's core business is salvageable with new management and a debt restructuring.

Distress Capital purchases $10 million face value of Alpha Corp's bonds at a price of $400 per bond, totaling an investment of $4 million. This acquisition is an investment in distressed securities. Should Alpha Corp successfully undergo restructuring, perhaps converting some debt into equity or extending maturity dates, and its financial health improves, the value of these bonds could recover. If the bonds eventually trade at $700 per bond after a successful turnaround, Distress Capital could sell its holdings for $7 million, realizing a $3 million gain on its $4 million investment, excluding any accrued interest or legal fees.

Conversely, if Alpha Corp enters liquidation and the bondholders recover only $100 per bond, Distress Capital would only retrieve $1 million from its initial $4 million investment, resulting in a substantial loss.

Practical Applications

Distressed securities are primarily found in the realm of specialized investing, pursued by sophisticated institutional investors such as hedge funds, private equity firms, and dedicated distressed debt funds. These entities actively seek out opportunities arising from corporate financial distress, which may stem from excessive leverage, operational missteps, or adverse economic conditions.

One common application is taking an active role in a company's restructuring or bankruptcy proceedings. By acquiring a significant portion of a company's distressed debt, investors can gain influence over the reorganization plan, potentially converting their debt into equity to take control of the company (a "loan-to-own" strategy). Other strategies include pure arbitrage plays, where investors exploit pricing inefficiencies between different securities of the same distressed issuer.

The distressed debt market provides a vital, albeit risky, source of capital for troubled companies, often facilitating their reorganization and preventing outright liquidation, thereby preserving jobs and economic value. The overall delinquency rate on loans at commercial banks in the U.S. can serve as a broad indicator of the health of credit markets and potential distressed opportunities. As of Q1 2025, the delinquency rate on all loans at all commercial banks in the United States was 1.56%.¹⁰,⁹

Limitations and Criticisms

Investing in distressed securities comes with significant limitations and criticisms. The inherent volatility and uncertainty of a company's future mean there is a heightened risk of default and substantial loss of principal.⁸ The success of distressed investing often hinges on complex legal proceedings, such as bankruptcy and restructuring, which can be time-consuming, costly, and unpredictable.⁷ Gaps in information can exist, especially for private companies, making accurate due diligence challenging.⁶

Critics sometimes refer to distressed debt investors as "vulture investors" due to the opportunistic nature of acquiring assets from struggling entities.⁵,⁴ While these investors often provide essential capital that can prevent liquidation, concerns can arise regarding potential creditor opportunism, where activist distressed debt investors might leverage their position to extract gains at the expense of other stakeholders or the debtor itself.³ The risks are highly firm-specific and idiosyncratic, requiring investors adept at managing these complexities, understanding legal rules, and skilled at identifying or creating value in distressed situations.² Market illiquidity can also pose a significant challenge, making it difficult to exit positions without incurring substantial discounts.¹

Distressed Securities vs. High-Yield Bonds

Distressed securities and high-yield bonds are distinct financial instruments, though both involve elevated levels of credit risk. The key difference lies in the degree of financial health of the issuer and the immediate expectation of default or bankruptcy.

While high-yield bonds are issued by companies with weaker credit profiles, they are generally still performing, meaning they are making their interest and principal payments. Distressed securities, by contrast, are from issuers already in acute financial trouble, where the focus shifts from receiving regular payments to recovering principal through complex legal and financial restructuring.

FAQs

What causes a security to become distressed?

A security becomes distressed when its issuer faces severe financial difficulties, such as unsustainable debt levels, consistent losses, declining revenue, or inability to meet debt obligations. These issues can lead to a credit rating downgrade, a heightened risk of default, or entry into bankruptcy proceedings.

Who typically invests in distressed securities?

Investing in distressed securities is generally undertaken by specialized institutional investors, including hedge funds, private equity firms, and dedicated distressed debt funds. These investors possess the necessary capital, expertise in complex financial analysis, and legal knowledge to navigate the intricacies of distressed situations.

How do investors make money from distressed securities?

Investors can profit from distressed securities in several ways: if the company successfully undergoes a restructuring and its financial health improves, leading to a rebound in the security's price; by converting debt into equity to gain control of the company and improve its operations; or by arbitraging pricing differences between various securities of the same distressed issuer.

What are the main risks associated with distressed securities?

The primary risks include the potential for complete loss of principal if the issuer enters liquidation and there are insufficient assets to cover claims. Other risks involve the lengthy and unpredictable nature of bankruptcy proceedings, market illiquidity, and the complex legal and financial analysis required to assess recovery prospects.

Is there a formula to predict if a company's securities will become distressed?

While there isn't a single definitive formula, financial models like the Altman Z-score are used to predict the likelihood of corporate bankruptcy within a certain timeframe. These models incorporate various financial ratios related to profitability, leverage, liquidity, and solvency to assign a score indicating a company's financial health.