Story Of Interest
Written By: Karen Leung
Securities are financial instruments that have financial value and are usually categorized as debt or equity. They are created when a company issues them as a way to raise money and can be purchased as an investment. In some cases, the issuer may be unable to meet the obligations agreed at the issuing time of the security and alternative arrangements are required. The most common case occurs when companies are at risk of bankruptcy and need to decide on next steps. This situation creates the distressed securities market, dominated by distressed debt.
Options for Distressed Companies
A distressed company must decide whether the best plan of action is to liquidate, restructure, or a combination of both. When a company liquidates, they are filing for Chapter 7 bankruptcy meaning it ceases operations and the remaining funds of the company are distributed to creditors based on seniority. When a company restructures, they are filing for Chapter 11 bankruptcy and plan on restructuring the company and improving its operations. This situation can be very profitable for distressed debt investors if they purchased bonds at deep discounts and the company made a successful recovery.
Many investors are under strict regulations and unable to hold below investment grade securities. When a company is at risk of bankruptcy, the share prices approach zero and the credit ratings of the bonds are downgraded. Many investors holding these risky bonds are looking to get rid of their positions and often sell them at a deep discount. Further, when they see a strong probability for a downfall, they may be mandated to close their positions. This provides an opportunity for private equity firms, hedge funds, and investment banks to be major players in the distressed debt industry. They are able to take on higher risks and provide abnormally high returns by investing in high yield bonds and senior loans.
During a financial downturn, there will be the most opportunities for distressed investors. Therefore, signals that indicate a recession should be closely followed. A yield curve indicates the relationship between interest rates and time to maturity. The usual shape in a healthy economy shows lower yields at a shorter time to maturity and higher yields at a longer time to maturity. Today, the yield curve has been observed to be flattening with the shorter-dated yields increasing and longer-dated bonds remaining stable. This indicates that investors are losing confidence in the shorter-dated bonds and selling them. Another indicator is rate hikes. It was just announced that the Federal Reserve does not plan to raise rates in 2019 because they are projecting an economic slowdown. If monetary policy continues to tighten, it may render many creditors unable to fulfill their debt obligations because rates are too high. Finally, economic indicators from reports like the non-farm payroll should be closely monitored. When the report is positive, it shows that additional jobs were created compared to the previous month meaning the economy is likely healthy and growing. The chart indicates very weak job growth doubting the strength of the labour market. In conclusion, it is predicted that the distressed debt market will have many opportunities in the near future.