Debt-for-Equity Bond Exchanges: How Might They Affect You?

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Debt-for-Equity Bond Exchanges: How Might They Affect You?
by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
Updated June 15, 2009

Six Flags, Harrah’s, GMAC, Ford, GM, Chrysler: Other than a healthy dose of financial trouble, what do these companies have in common? All have increasingly been seeking to restructure, repurchase or exchange their bonds and other debt obligations for a mix of new bonds, stock or cash.

In early March, Ford offered to buy back 40% of its outstanding bonds—at a steep discount to the original par amount. GMAC did the same in January. GM attempted, but failed, to convince bondholders to exchange their bonds for stock in an effort to help avoid bankruptcy.

If you're a bond investor, what does this mean? Should you be concerned that your bond investments might not be "guaranteed" after all?

What is a bond exchange?
A bond exchange is an offer by a company that has borrowed money by selling corporate bonds to exchange those bonds for new securities (or cash). Sometimes exchanges are for more than the bonds would be worth if a bondholder chose to sell.

But, more recently, a rising number of distressed companies have offered exchanges for a lesser mix of stock, securities or cash, near or below prices that have already dropped sharply in the open market.

Here's an example of a recent exchange offered by Ford:

Bondholders were offered 108 shares of Ford stock and $80 in cash for every $1,000 in bonds (based on the original principal [“par”] amount).
The value was worth roughly 28 cents on the original dollar in par, at the time of the offer—far less than the original investment.
The value of the offer would change, depending on changes in Ford's stock price.

Debt restructuring is designed to make the company more viable by reducing interest costs. Common stock, in contrast to bonds, offers an ownership interest but no promised dividends or interest payments.

If company performance rebounds, so the argument goes—it might be worth the sacrifice.

If not, in examples of extreme distress, bankruptcy might be the final option. In bankruptcy, the value left over for bondholders could be far less, and is at the mercy of a bankruptcy court.

Why would investors agree?
Investors might agree to such an exchange for two reasons:

If they do, they'll be better off. The company might offer to repurchase bonds at more than they'd be worth if the investor chose to sell now, though less than they'd receive if they held the bonds until maturity, if the company were actually still able to pay.
If they don't, they'll be worse off. This is often called a "coercive" exchange—the company uses a stick rather than a carrot to force enough bondholders to agree. The threat of bankruptcy, or some other change in terms, can often be enough to induce enough bondholders to go along.

Short of bankruptcy, participation is generally voluntary. And it's not guaranteed that all investors will be included. For logistical reasons, it can often be easier for the company to go straight to a collection of the largest institutional bondholders to negotiate terms. They might not need, and might not seek, 100% participation from all investors.

This was the case with a recent repurchase (or “tender”) offer by GMAC. Retail bondholders, including investors in GMAC’s SmartNote program, were not included. In the end, those investors actually fared better. GMAC has continued to make interest ("coupon") and principal payments to those who remain bondholders.

However, in some cases, weak protections in the legal guarantees to bondholders (summarized in the prospectus and the bond "indenture") might allow a majority of bondholders to change the terms for bondholders who don't agree.

For example, in GM’s last-ditch effort to stave off bankruptcy in May, bondholders were offered the exchange of 225 shares of common stock for every $1,000 in bonds (based on original par). Those who were asked to agree to this exchange were also asked to change the terms for remaining investors—in this case, to insert an option for GM to “call” (or force prepayment) of any remaining bonds, for the same 225 in common shares. A clause in the original agreements (or bond “indenture”) allowed them to do so.

Though not enough bondholders finally agreed in the end, and GM filed for bankruptcy, this was a true coercive exchange—bondholders who didn't agree might have been pulled along as well. This has been one side effect of the easy-credit environment of the past decade, in our opinion—a weakening of legal protections to bondholders in the event of corporate distress.

If you're a corporate bond investor, should you be concerned?
For many individual investors, the best strategy might be to ignore the daily news and accept that the negotiations of large institutional investors are out of your control. But to further understand the considerable risks involved, be sure to read the terms of the exchange carefully. If you're well-diversified, you're likely to be better positioned to live more comfortably with your investment.

But we know that many investors might not be in this position. A decision will depend on the situation, and the terms. And there are few certainties. A "successful" bond exchange, or "restructuring," isn't a cure-all for all company ills, for anyone still holding a stake in the firm in the form of stock or remaining bonds.

As always, if you have questions or need help for a particular issue or your own bond portfolio, please contact your Schwab consultant or a Fixed Income Specialist at 800-626-4600.

Important Disclosures

Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors.

When a bond is purchased or sold, Schwab charges a commission, markup or markdown. Individual bonds are subject to the credit risk of the issuer. Changes in interest rates can affect a bond's market value prior to call or maturity.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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