The structural factors relating to bankruptcy securities can be both legal and psychological. As an example of a legal factor, many institutional investors (such as insurance companies or mutual funds) are not allowed, either by law or by their charter, to hold bonds that have defaulted and no longer pay interest. Therefore, they will immediately sell the bond as soon as it defaults, regardless of the ultimate value of that bond. Or perhaps the institutional investor can own a defaulted bond, but it is not permitted to hold stock. That institution will have to immediately dump any stock it receives in exchange for a bond in a reorganization.

On the psychological side, the word “bankruptcy” has such a negative connotation for most people that they will not go near a security of a company that is in Chapter 11 or that has recently emerged.

(Question submitted by Yusen L.)

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