What is an Adjustment Bond
An adjustment bond is issued by a corporation when it restructures its debts to cope with financial difficulties or potential bankruptcy. During a restructuring, holders of existing, outstanding bonds receive adjustment bonds. This issue allows for the consolidation of the debt obligation to the new bonds. Adjustment bonds become an alternative to bankruptcy if a company’s financial difficulties make it difficult to make debt payments.
BREAKING DOWN Adjustment Bond
Adjustment bonds have a structure where interest payments happen only when the company has earnings. The company does not fall into default for unmade payments. This effectively recapitalizes the company's outstanding debt obligations. It also allows the company the chance to adjust terms such as interest rates and time to maturity giving the company a better opportunity to meet its commitments without entering bankruptcy.
In a Chapter 11 bankruptcy, the company would be liquidated with all of its assets sold or allocated to creditors. Usually, however, such a bankruptcy generates only a fraction of the money creditors are owed. Adjustment bonds provide an incentive for a company and its creditors to work together. The company can reorganize its debts in a way that allows the company to continue its operations, increasing the chances that creditors will be paid more than if the company is liquidated.
How Adjustment Bonds Work
A company facing financial difficulties will generally meet with its creditors, including bondholders, to negotiate an arrangement more preferable than bankruptcy. Issuing adjustment bonds requires the permission of existing bondholders.
The terms of such a bond often include a provision that when a company generates positive earnings, it is required to pay interest. If revenues are negative, no interest payment is due. Depending upon the specific term of an adjustment bond, any missed interest payments may be fully accrued, partially accrued, or not accrued. In addition, because negative earnings do not create an obligation to pay interest, the company avoids the embarrassment of being deemed in default on its debt. Adjustment bonds can offer a tax advantage because any interest paid is a tax-deductible expense.
Adjustment bonds may help companies maintain viability and avoid bankruptcy, yet creditors may be required to wait for many years to be repaid. Also, other options for reorganizing a company’s capital structure might include a debt to equity exchange.
In 1895, the Santa Fe Pacific Corporation faced significant financial difficulties and arranged to restructure $51.7 million of its debts into a new adjustment bond. According to the New York Times, the issue included terms which allowed the railroad to pay interest until 1900 only “if it felt it had sufficient earnings to make the payments.” After that, the railroad “could not just forget about payments, but it could defer them, indefinitely if need be.” It took nearly 100 years, but that debt was finally paid off in 1995 when the company was acquired by Burlington Northern Inc.