Video: Debt to Equity Swaps Explained

Even if you're not a bondholder and only buy stocks, this could affect you. So read this carefully.

While looking for something else, I stumbled across this video. (Isn't that how most of us find our BEST stuff...when we're really not looking for it?)

This video is narrated by Paddy Hirsch, which I don't know who he is truthfully, but he has a neat sounding English accent (or something similar). That just nearly guarantees us folks here in the US will assume that he's smart.

Luckily, he seems to be right on the money.

In this video (under 7 minutes), he explains how the Debt-to-Equity swaps work:

Hirsch uses an airplane to describe the order of who gets paid first in the event of a bankruptcy and how debt-to-equity swaps work.

Below, I try to explain this concept and use an example to clarify it.

Tough Times: One Strategy

A company essentially has two (2) types of assets: Debt and Equity.

There are several types of each, but to make this point, we will stick with these two.

When a company is doing well, it is making enough money to cover the debt service, which is the ongoing payment it needs to make to continue borrowing money without having to repay the entire amount immediately.

However, during more turbulent times, the company might NOT be making enough money to cover its debt service.

One strategy is for the company to try convincing its bond holders (debt) to remove its demand to repay the loan in exchange for partial ownership in the company in the form of stock shares (equity).

Another words, if I don't have to repay you (debt), then you can own part of my company (equity).

This is called a debt-to-equity swap.

How does the company benefit from this?

When the company successfully convinces some or all of its bond holders to swap its bond obligation (debt) for stock ownership (equity), it reduces the amount of its ongoing debt service.

Looking at things from a personal perspective, how much easier would it be for you to survive if you suddenly didn't have to make your mortgage payment each month? That mortgage payment is a personal example of debt service. You owe more than you're paying each month, but you're obligated to pay a certain amount each month as long as you have not fully repaid your loan.

So now the company has fewer expenses, which makes it easier to make money and be profitable again.

Is there a downside for the company when they do this?

Since it has fewer expenses, is there any downside for the company to swap debt for equity?

Absolutely YES!

It has less leverage over its own company now.

Think of the above stated example.

If your father-in-law suddenly pays off your home, do your expenses drop drastically? Probably, yes.

Have you lost some freedom in your decision making in the near future?

The answer depends upon the specific family and individuals involved, but I think you get the idea.

That is what happens to the company when they swap. Plus, they are entitled to a smaller share of the profits now since they gave up some equity.

Why would a bondholder swap for equity?

In a debt-to-equity swap, the benefit to the company is pretty clear, but doesn't it depend upon the person holding the bond (debt) to agree to swap that for stock (equity)?

It does.

So why would that person be willing to do that?

There are two (2) main reasons to do this:

1. Minimize Short Term Loss
2. Maximize Long Term Gain

There really is not any other reason, but let me explain each here:

1. Minimize Short Term Loss

When a company liquidates, ideally everyone gets paid, but that is not how it usually works.

Each asset class gets paid--IN FULL--in the following order:

1. Loan Holders (Banks and Vendors with Outstanding Account Receivables owed to them)
   
2. Bond Holders
3. Preferred Stock Holders
4. Common Stock Holders

If you are a bond holder, you get paid before stock holders do, but you aren't paid UNTIL the other loan obligations are paid IN FULL first.

So if you see yourself not getting paid in full, you start looking at other options.

In fact, you start looking for ways to keep that company from having to liquidate. Unless you are part of the management team, one way to do this is to find a way to make it easier for them to survive. You swap your debt in exchange for equity, which lowers the company's monthly (so to speak) expenses.

2. Maximize Long Term Gain

If the company does really well and makes a turnaround, that stock (equity) could be worth more than your original debt was to you.

Example:

In early 2009, Ford offered its bondholders to exchange its bonds for for stock at the rate of 27 cents on the dollar.

That means that their bond, originally worth $1,000, would get them $270.

That does not sound like a very good deal, does it?

Let's look further at this example.

If bondholders were unwilling to exchange, they could have ended with $0. Truthfully, this is not likely, but GM bondholders were only paid 10 cents on the dollar ($100 for their $1,000 bond). So it could have been worse.

At that time, the stock was worth around $1.50/share. So $270 got them roughly 180 shares.

Today, Ford stock is worth roughly $17/share. At that rate, 180 shares is worth over $3,000.

So by temporarily exchanging a $1,000 bond (debt) for $270 of stock (equity), they later turned that into over $3,000.

Was THAT a good exchange for Ford, who would have gone bankrupt, otherwise?

Yes!

Was THAT a good exchange for the bondholder who did the debt-to-equity swap?

I think so!

Beware: The story does not always end this way.

However, if you own stock, and you see that the company is offering debt-for-equity swaps, it could mean a very good thing for your stock price.

You just have to evaluate whether you think the company has a good plan once the debt is reduced.