Distressed securities

When a company runs into serious financial trouble, its securities do not simply fall in price — they often collapse, far below what a patient analysis of the business might justify.

The workbook explains why. Distressed securities are securities of a company that is on the verge of or has entered bankruptcy, or has seen a massive fall in its credit rating. They include the company's equities, bonds and even trade debt.

Banks, mutual funds and insurance companies — the traditional holders — face regulatory limits on investing in low-rated companies. So when a company becomes distressed, they generally exit even at low prices. Forced sellers with few natural buyers push prices to a steep discount to face value.

That discount is the opportunity — for investors who are allowed to take it and able to judge it.

The workbook's chain of cause and effect:

1. Distress. Bankruptcy is near or has begun, or the credit rating falls sharply.
2. Regulated investors must leave. Banks, mutual funds and insurers are subject to limits on low-rated holdings, so they sell, even cheaply.
3. Prices overshoot. The securities "often trade at a steep discount to their face value".
4. Unregulated capital steps in. Investors such as hedge funds, which are not subject to the same regulations and can take higher risks, see an attractive opportunity.

Where it sits. The workbook lists distressed securities among the asset classes apart from debt and equity — alongside hybrids, commodities, derivatives, mutual funds, structured products, Electronic Gold Receipts and ZCZP instruments — and names "commodities, structured products and distressed securities" as the alternative asset classes covered in Chapter 2.

Who it suits. "Sophisticated investors who can properly analyse the risk-return trade-off from such securities." It is not presented as a retail product; compare the workbook's statement that mutual funds and commodity ETFs are suitable for retail investors.

Return (%) = (Amount eventually recovered − Price paid) ÷ Price paid × 100
Discount to face value (%) = (Face value − Market price) ÷ Face value × 100

Illustrative figures. The bonds of Konkan Shipyards (face value Rs 1,000) are downgraded several notches after it misses payments. A debt mutual fund, bound by limits on low-rated paper, sells its holding at Rs 450 a bond.

Discount to face value = (1,000 − 450) ÷ 1,000 × 100 = 55 per cent

A hedge fund buys 10,000 bonds:

Cost = 10,000 × Rs 450 = Rs 45,00,000

Its outcome depends entirely on what the company eventually pays:

The same Rs 250 swing either side of the purchase price becomes a 55.6 per cent gain or a 55.6 per cent loss. The fund's edge is not the discount itself — the discount was available to anyone — but its ability to analyse which outcome is likelier, and its freedom to hold a paper that the mutual fund was not allowed to keep.

Chapter 2 (Securities: Types, Features and Concepts of Asset Allocation and Investing) lists distressed securities among the products "apart from debt and equity", and its learning objectives name them with commodities and structured products as alternative asset classes. Expect a definition or a suitability question — distressed securities suit sophisticated investors such as hedge funds, not retail investors — and the reason for the discount: regulated investors' limits on low-rated holdings.

• Not only bonds. The workbook includes equities, bonds and even trade debt of the distressed company.
• Two triggers: being on the verge of or in bankruptcy, or a massive fall in credit rating.
• The discount is driven by forced selling from banks, mutual funds and insurers facing regulatory limits — not only by the company's problems.
• Hedge funds can buy because they are not subject to the same regulations, not because distressed securities are safe.
• Suitable for sophisticated investors, not retail.
• A steep discount is not a margin of safety. Recovery can be lower than the price paid.