Distressed Securities

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 (e.g. 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 & Poor's, Moody's 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 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. See Business valuation: Option pricing approaches.