Distressed Securities are the financial instrument that is issued by a government institution or a company experiencing financial distress, default risk, or on a verge of, if not already in, bankruptcy. Distressed securities include bonds, common & preferred shares, bank debt, and other financial claims. Distressed securities are sold at a large discount and seen as an opportunity for investors to buy such assets at a reduced price.
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How Do They Work?
Distressed securities are highly risky in nature. Since they are traded at a discount, aggressive investors find it as an opportunity to buy those securities at a lower price with a belief that in the long term these securities will be worth more than their current market price and earn in bulks based on the potential risk-reward matrix of investing in such distressed security. However, not all investors find such an investment attractive. Some of them find it riskier than the potential future rewards and avoids trading in such distressed security. Speculators such as hedge fund trade when the company is on a brink of bankruptcy.
Investment in Distressed Securities:
- While making an investment in distressed security certain aspects should be assessed or taken into consideration like the organization’s fundamentals, an absolute understanding of the organization’s recovery and restructuring plans, their competitors, capital structure, measures taken to improve their financial health, and other internal or external factors that could impact the organization.
- The assessment will be based on the type of investment the investor wants to make i.e., whether he wants to buy at a low price and hold it for long-term or whether he wants to invest for a short-term period and close his position as soon as he earns the target profit.
- In the case of hedge funds, they buy at a low value with an expectancy that the organization’s value will rise which will generate massive profits for the hedge funds. But if the situation reverses then hedge funds may incur losses.
- Mutual Funds, hedge funds, private equity firms, and large institutional investors are the major investors of distressed securities.
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Risk of Investing in Distressed Securities:
- There is a high level of uncertainty involved in predicting future price levels.
- In case if the anticipation goes wrong then the investor will incur massive loss depending on the investment made.
- There should be a diversified approach used for investing since there is a high level of risk involved the investor should be aware of all the necessary aspects. In simple words, he should keep himself updated.
- There may be other unexpected factors that could impact the organization’s growth. So an investor should follow a risk management strategy.
Investment in distressed securities is for those ready to take a high risk for massive profits and do not fear to plunge into the investment sector. Investors can mitigate their risks by adopting the right skillset by gaining knowledge and experience in this market.
Author – Divyashri Kadam
About The Author – Divyashri is a Bachelor’s Degree Holder in Accounting and Finance. Also, a Certified Financial Modeling and Valuation Analyst (FMVA). She is enthusiastic to learn more about financial markets, financial analysis, and anything relating to stocks.