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What is a Distressed Security?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 25 November 2016
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Distressed securities are investment opportunities associated with an entity that is either going through a difficult time financially or projected to shortly enter a period of being non-profitable. Both governments and businesses may find their securities distressed by adverse conditions. As a general rule, investors tend to evaluate the situation thoroughly before choosing to purchase a distressed security.

There are several sets of circumstances that indicate that a security is currently under duress and may not be a wise investment option. Companies which are currently in default on a number of financial obligations will quickly find their stock offerings are not as strong as they were previously. In the event that the company seeks bankruptcy as a means of ironing out current financial difficulties, there is a good chance that investors will not purchase shares in at least the short term. Even if there are indications that a company is about to enter a period of insolvency, investors may hesitate to purchase any shares of a distressed security.

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One key factor that sometimes attracts new investors to a distressed security is what effort the company is taking to become profitable again. If the business plan indicates that there is a real possibility that the corporation can correct the issues that led to the weakened position of the shares, investors are more open to purchasing shares and biding their time as the plan unfolds. In the United States, it is not unusual for investment partnerships to form, making it possible to pool resources to purchase the currently depressed security offerings. Private equity firms, brokerage houses, and mutual funds also sometimes will take a chance on a distressed security that is anticipated to rebound at a later date.

While buying up shares of a distressed security is among the more risky investments possible, it also often has tremendous potential for yield a large return. For investors who can afford to hold on to the shares while the company goes through a reorganization and recovery period, there is every chance that any losses will quickly be offset by earnings as the shares begin to post higher on various markets. However, care should be taken to fully investigate the strategies involved with the recovery effort. If the investor is not convinced that there is a reasonable chance for the company to become profitable once more, passing on the distressed security is most likely the wisest move.

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