Financial Education » Investing in Distressed Securities

Risk Factors Related to Investments in Distressed Securities

William Trent — Fri, 28 Nov 2008 12:29:45 +0000

Market risks related to the economy, interest rates, and the state of the market are relatively unimportant when considering investments in distressed securities. There are, however, several types of risks that particularly apply to investments in distressed securities.

Event risk relates to unexpected company-specific or situation-specific events that affect valuation.

Market liquidity risk arises because distressed securities are less liquid, and demand runs in cycles.

J-factor risk relates to the judge presiding over bankruptcy proceedings. The track record in adjudication and restructuring can play a significant role in both the overall outcome and determining the optimum securities in which to invest.

Investing in Distressed Securities

William Trent — Tue, 28 Oct 2008 12:16:58 +0000

Investors seeking exposure to securities issued by companies in distress are typically seeking higher returns in exchange for the added risks. Success in distressed security investment requires unique skills, and typically investors participate via vehicles such as hedge funds or private equity funds. Hedge funds offer greater liquidity for the investor (and greater access to capital for the manager.) However, the illiquid nature of many distressed securities may confer advantages to the fixed term and closed-end structure of private equity funds.

There are a number of security types that relate to distressed companies:

The publicly traded debt and equity
Newly issued (orphan) equity of companies recently emerged from reorganization
Bank debt and trade claims that the original creditor may wish to monetize
“Lender of last resort” notes

Frequently investors use these securities in conjunction with a range of derivative products to hedge related risks.

The reasons distressed securities can offer high risk-adjusted returns relates to the market opportunity that arises because other investors are either unwilling or unable to participate in the market. Some funds are prohibited from owning speculative grade debt, and are forced to sell holdings that lose an investment grade rating regardless of price. Others do not wish to participate in drawn-out bankruptcy proceedings and will accept a fraction of the value of their claims in exchange for immediate cash. In other cases, failed leveraged buyouts or unduly shunned companies that recently emerged from bankruptcy may create a temporary imbalance of supply and demand for their securities.

High Yield Bond Returns: Downgrades versus Original Issues

William Trent — Mon, 06 Oct 2008 12:52:06 +0000

Bonds may either be issued as speculative grade bonds (original issue)or become so following a rating downgrade (fallen angels). In either case, their risk-adjusted returns should be similar. However, in an article published in the Fall 2007Journal of Portfolio Management Fridson and Sterling point out that fallen angels have historically delivered far higher risk-adjusted returns, and discuss several explanations for an apparent market inefficiency.

The authors find the correlation between fallen angels and original-issue speculative grade debt to be lower than that between Treasuries and investment-grade corporate bonds, suggesting dissimilar attributes and below the threshold normally used to classify securities as part of the same asset class.

Possible reasons for the disparity include:

Lack of investor awareness, given that the primary high-yield index only recently began breaking out the performance of the two categories
Emphasis on security selection and possible overconfidence among managers that they can pick the superior original-issue bonds
Investability – fallen angels account for just 30% of available speculative-grade debt and trade infrequently
Lottery-like returns for specific original issue bonds
Yield appeal due to higher yields typically found with original issue bonds