Distressed Securities

In Finance Management, Distressed securities are securities of companies or government entities 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 1000 basis points over the risk-free rate of return (for example, Treasuries) are commonly thought of as being distressed. A related category is stressed debt yielding between 600-800 basis points over

Treasuries. Distressed securities often carry ratings of CCC or below from agencies such as Standard & Poors, Moodys and Fitch.

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, private equity firms 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 turn around its operations. Investors may also invest new capital into a distressed company in the form of debt or equity.

The United States 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 insolvency laws have been modernized.

Investors in distressed securities typically must make an assessment not only of the issuers 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.

Investing in Distressed Securities

Distressed securities may be an attractive investment option for sophisticated investors who are looking for a bargain and are willing to accept some risk. Investors in distressed securities must be willing to accept significant risk, however. Most distressed securities are issued by companies that end up filing for bankruptcy. When this happens, some distressed securities are rendered worthless. For example, when a company goes bankrupt, its common stock has no value (which is why many investors limit their investments to more senior distressed securities, such as corporate bonds, bank debt and trade claims). As a result, investors in distressed securities must have the knowledge and skill to accurately assess whether the issuer (the company in distress) can improve its operations and successfully reorganizeand if so, which of its securities will benefit.

Owing to the risks involved, large institutional investorssuch as hedge funds, private equity firms and investment banksare the major buyers of distressed securities. Often, these investorsalone or in conjunction with other distressed investorswill try to influence the process by which the issuing company reorganizes. Sometimes, the investors will inject new capital into the company in exchange for, say, equity.

In summary, then, while a company teetering on the edge of bankruptcy may not sound like a great investment opportunity, it could befor sophisticated investors who understand investing in distressed securities and are willing to accept the risks.

Why Do Hedge Funds Love Distressed Debt

Hedge funds can generate massive returns in relatively short periods of time, and they can also go into financial crises just as quickly. What kind of investments can produce such diverse returns? One answer is distressed debt. The term can be loosely defined as the debt of companies that have filed for bankruptcy or have a significant chance of filing for bankruptcy in the near future.

You might wonder why a hedge fund — or any investor, for that matter — would want to invest in bonds with such a high likelihood of defaulting. The answer is simple: the more risk you take on, the more reward you can potentially make. Distressed debt sells at a very low percentage of par values. If the once-distressed company emerges from bankruptcy as a viable firm, that once-distressed debt will be selling for a considerably higher price. These potentially large returns attract investors, particularly investors such as hedge funds. In this article well look at the connection between hedge funds and distressed debt, what ordinary investors can do to get involved and if the risks are really worth the rewards.

Many would assume that collateralized debt would be immune from becoming distressed due to the collateral backing it, but this assumption is incorrect. If the value of the collateral decreases and the debtor also goes into default, the bonds price will fall significantly. Debt such as mortgage-backed securities during the U.S. subprime mortgage crisis would be a great example.

The Hedge Fund Perspective

Access to distressed debt comes in many forms for hedge funds and other large institutional investors. In general these forms can be broken into three methods: the bond market, mutual funds and the distressed firm itself. Lets take a closer look at these three:

1. Bond market - The easiest way to acquire distressed debt is through the market. Such debt easily can be acquired from the bond market due to regulations concerning the holdings of mutual funds. Most mutual funds are not allowed to hold securities that have defaulted. Due to these rules, a large supply of debt is available shortly after a firm defaults.
2. Mutual funds - Hedge funds can also buy directly from mutual funds. This method benefits both parties involved. In a single transaction, hedge funds can acquire larger quantities — and mutual funds can sell larger quantities — both without having to worry about how such large quantities will affect market prices. Both parties also avoid paying exchange-generated commissions.
3. Distressed firm - The third option is perhaps the most interesting. This involves directly working with the company to extend it credit on behalf of the fund. This credit can be in the form of bonds or even a revolving credit line. The distressed firm usually needs a lot of cash to turn things around; if more than one hedge fund extends credit, then none of the funds are overexposed to the default risk tied to one investment. This is why multiple hedge funds and investment banks usually undertake the endeavor together.

Hedge funds sometimes take on an active role with the distressed firm. Some funds who own the debt can provide direction to management, which may be inexperienced with bankruptcy situations. By having more control over their investment, the hedge funds involved can improve their chances of success. Hedge funds can also alter the terms of repayment for the debt to provide the company with more flexibility, freeing it up to correct other problems.

So, what is the risk to the hedge funds involved? Owning the debt of a distressed company is more advantageous than owning its equity in case of bankruptcy. This is because debt has precedence over equity in its claim to assets if the company is dissolved (the rule is called absolute priority). This does not, however, guarantee a financial reimbursement. (To learn why debtholders get paid first

Hedge funds limit losses by taking small positions relative to their overall size. Because distressed debt can offer such potentially high-percentage returns, even relatively small investments can add hundreds of basis points to a funds overall return on capital. A simple example of this would be taking 1% of the hedge funds capital and investing it in the distressed debt of a particular firm. If this distressed firm emerges from bankruptcy and its debt goes from 20 cents on the dollar to 80 cents on the dollar, the hedge fund makes a 300% return on its investment and a 3% return on its total capital

The world of distressed debt has its ups and downs, but hedge funds and sophisticated individual investors have a lot to gain from the risks taken. By controlling their risks, each in their own ways, both can earn great rewards for successful navigation through a firms tough times.