Distressed securities are financial instruments issued by a company that is near to or currently going through bankruptcy. As a result of the issuing company’s inability to meet its financial obligations, these financial instruments have suffered a substantial reduction in value, but because of their implicit riskiness, they offer investors the potential for high returns. Distressed securities can include common and preferred shares, bank debt, trade claims and corporate bonds. – Investopedia
So how to explain them?
There are some investors who have a large risk appetite and so does Sufficient big expected return. Buying stock, Bonds, sovereign debt, Preferred shares, annuity are not the financial assets which they love to invest. like Hedge Funds, pension funds or insurance, Endowment funds or Private equity. Yes. They will invest in them also but for increasing the return, These BIG BOYS on Wall Street ( or Dalal Street if you are from India) will invest in such securities.
On the other hand when the economy is on the bullish trend, Maybe there are some industrialists who may choose debt over equity as the cost of debt Net of taxes is low. Maybe their debt to equity will look good but the coverage ratio will not look good. Their Capital structure maybe heavy for Debt. one another sign to found such companies is the Large difference in between ROCE and ROE. Generally, when the company doesn’t have much debt, these two ratios go hand in hand hardly one or two percent difference. But as Weight of debt increased so does Difference will start increasing. At some point, some of them maybe fail to pay interest. Reasons maybe many. Maybe some of them was a star for the market.
Investors looking for a bargain and willing to accept a risk often become interested in distressed securities. In some cases, these investors believe the company’s situation is not as bad as it looks, and as a result, they anticipate their investments to increase in value. In other cases, investors may foresee the company going into bankruptcy, but they feel confident that there might be enough money upon liquidation to cover the securities they have purchased.
In recent days, in India NPA issue due to many NPAs specifically, 12 large distress assets are sufficiently big. Most of them were once market darling. But due to some MISCALCULATIONS, they went to Bankruptcy. IN US you people call it Chapter 11 or chapter 7 bankruptcy. In particular, if a business files chapter 7 bankruptcy, it stops operations and goes into liquidation, at which point its funds are dispensed to its creditors, including bondholders. Conversely, under chapter 11 bankruptcy, a business restructures and continues operations. If reorganization is successful, its distressed securities, including both stocks and bonds, may yield surprising amounts of profits.
Securities are labeled as distressed when the company issuing them is unable to meet many of its financial obligations. In most cases, these securities carry a CCC or below credit rating from debt-rating agencies, such as Standard and Poor’s or Moody’s Investor Services. Distressed securities contrast with junk bonds, which traditionally have a credit rating of BBB or lower.
Additionally, the anticipated rate of return on a distressed security is more than 1,000 basis points above the rate of return of a so-called risk-free asset, such as a U.S. Treasury bill or bond. For example, if the yield on a five-year Treasury bond is 1%, a distressed corporate bond has a rate of return of 11% or higher, based on the fact that one basis point equates to 0.01%.
In India most companies in two lists (12 + 25) of RBI was leaders in their field. Bhushan Steel (Rs44,478 crore), Essar Steel (Rs37,284 crore), Bhusan Power and Steel (Rs37,248 crore), Alok Industries (Rs22,075 crore), Amtek Auto (Rs14,074 crore) and Monnet Ispat (Rs 12,115 crore), Lanco Infra (Rs44,364.6 cr), Electrosteel Steels (Rs10,273.6 crore), Era Infra (Rs10,065.4 crore), Jypaee Infratech (Rs9,635 crore), ABG Shipyard (Rs6,953 crore) and Jyoti Structures (Rs5,165 crore).