Final answer:
Buying preferred shares of a bankrupt company could potentially yield returns in a liquidation, but it also carries a high risk as bondholders are prioritized in asset distributions. Preferred shareholders are secondary to bondholders and might not fully recover their investment. Diversification across various bonds can reduce overall investment risk.
Step-by-step explanation:
The question asks whether it is a smart strategy to purchase the preferred shares of a company in the event of bankruptcy to benefit from the liquidation process. When a corporation goes bankrupt, the bondholders are typically given priority in repayment over other types of investors. A bond issuer is obligated to make specified payments and in case of bankruptcy, assets are liquidated to honor these commitments as much as possible. Preferred shareholders have a higher claim on assets than common shareholders but are still behind bondholders. While buying preferred shares can be seen as a way to capitalize on liquidation, it's important to understand the risks involved. There is no guarantee of recovering the full investment, and in many cases, preferred shareholders might receive significantly less than what was invested as bondholders take precedence.
Diversifying investments through buying bonds from a mixture of companies can be a wise investor strategy to minimize risks associated with individual companies failing to meet their obligations. By spreading out investments, the impact of any single company's bankruptcy becomes less detrimental to the overall portfolio. This diversification approach is especially useful when dealing with junk bonds, which carry higher risk but also offer higher potential returns.