Distressed debt

Distressed securities are securities over companies or government entities that are experiencing financial or operational distress, default, or are under bankruptcy. As far as debt securities, this is called distressed debt. Purchasing or holding such distressed-debt creates significant risk due to the possibility that bankruptcy may render such securities worthless (zero recovery).

The deliberate investment in distressed securities as a strategy while potentially lucrative has a significant levels of risk as the securities may become worthless. To do so requires significant levels of resources and expertise to analyze each instrument and assess its position in an issuer's capital structure along with the likelihood of ultimate recovery. Distressed securities tend to trade at substantial discounts to their intrinsic or par value and are therefore considered to be below investment grade. This usually limits the number of potential investors to large institutional investors—such as hedge funds, private equity firms and investment banks or specialist firms.

In 2012, Edward Altman, an expert on bankruptcy theory, estimated that there were "more than 200 financial institutions investing between $350-400 billion in the distressed debt market in the United States".

The market developed for distressed securities as the number of large public companies in financial distress increased in the 1980s and early 1990s. In 1992 Altman, who developed the Altman Z-score formula for predicting bankruptcy in 1968, estimated "the market value of the debt securities" of distressed firms as "approximately $20.5 billion, a $42.6 billion in face value". By 1993 the investment community had become increasingly interested in the potential market for distressed firms' debt. At that time distressed securities "yielded a minimum ten percent over comparable maturity of U.S. Treasury bonds... Adding private debt with public registration rights allows private bank debt and trade claims of defaulted and distressed companies to bring the total book value of defaulted and distressed securities to $284 billion, a market value of $177 billion."

The distressed securities investment strategy exploits the fact many investors are unable to hold securities that are below investment grade.

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