The very nature of Hedge funds and their investments is risky and speculative. Among the many long and short term securities that investors put their money in, Hedge Fund investments are considered the most dangerous because they fluctuate far too much for an average trader to opt for them.
What makes hedge funds so risky is the type of investments the owners of these companies invest in. From an entire portfolio of high and low yielding securities, you will see hedge funds choose the ones that are the most risky with a fair chance of resulting in loss.
One such favorite among Hedge Fund owners is Distressed Securities.
What Are Distressed Securities?
What are distressed securities and how do they become distressed? Distressed securities are bonds, stocks, debts and trade claims of companies that are experiencing financial or operational difficulties, also known as distress. The companies to whom these stocks and bonds belong are either bankrupt or heading towards bankruptcy, with little chance of survival.
Buying or holding these bonds or debts is considered highly risky because with the impending doom of being unable to pay for the loans, distress securities have a Zero Recovery Rate. Hence, if you are a holder of such a security, you will soon find that the bond has no value in the investment market. Since the company also has no power to repay its debts at a future date or continue operations, the securities it had previously issued have no importance.
How can one know which securities are distressed?
Singles of Distress for a Security
There are various signals that indicate a security is in distress and shouldnt be invested it. Investors and Financial Security Analysts are always on a lookout for these signals when they assess the viability of bonds, debts and stocks in a market place. In other words, how does a high or low performing security actually become distressed?
Some of the most important signals of distress are:
- A Debt Rating of CCC or below by one of the most acclaimed rating agencies, Moodys and Fitch or Standard & Poors. Such a low rating is a snapshot of the performance of the security and instantly tells investors of its fatal condition.
- A Yield to Maturity of 1000 Basis points above that of Risk-Free- Return. This means that if the return on a security (if held till it is matured) is 1000 points higher than that of US Treasury, it is a warning sign of distress.
Investors who hold securities that have been showing signs of distress are in a hurry to sell them to avoid losses. Since there is no demand for such bonds and debts, they are sold at a very low price on the trading floor. But who are they sold to? When demand is so low for securities that are almost bankrupt, how do sellers find buyers after all?
Are they worth investing in?
Surprisingly, there is an active market and a huge demand for distressed securities all around the world, and the United States in particular. According to Investment and Bankruptcy experts, distressed securities present a big challenge for investors who love to take risk. Hence, for a risk lover, an investment in distressed security poses an opportunity to either lose a lot or gain substantially.
This behavior is called the Distressed Security Investment Strategy and is widely practiced by Hedge Funds. An example will make this strategy clear. Lets assume that investors are selling a distressed security at rock bottom prices right now in the market. Institutional Investors who have a lot of financial backing and tech savvy Risk Management Tools buy the security at nil rates, with the speculation that the company will turn around before it goes bankrupt.
Together with experts, this institutional investor will now try to positively affect the operations of the failing company, in an attempt to make it successful. While there have been many cases where the distressed securities turned around with a lot of injected capital and efforts, it is well understood by the investors that buying distressed securities carries a lot of risk, more than any other investment on the trading floor.
Nonetheless, with this risk also comes the possibility of very high and substantial returns. Therefore, while distressed securities spell trouble for average investors, for Hedge Funds, they are often the best way to earn the most return.
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