What Is Death Spiral Debt?
Death spiral debt describes a type of convertible bond that forces the creation of an ever-increasing number of shares, inevitably leading to a steep drop in the price of shares.
In general, convertible debt is a bond that yields interest but also can be converted to a number of stock shares. It is a hybrid security with some attributes of both a bond and a stock.
The type of bond that can cause the death spiral effect is a convertible bond that can be converted to a set dollar value, paid in shares.
Understanding Death Spiral Debt
As noted, a conventional convertible bond can be converted to a fixed number of shares. The type of bond that is called death spiral debt, however, converts into a fixed value paid in shares.
- A conventional convertible bond can be converted into a set number of shares.
- The type of bond that can cause the death spiral effect converts to a set value, to be paid in shares.
- The more this type of bond is converted, the more shares are created and the lower the share price will go.
As a stock's price increases substantially, investors in conventional convertible shares are likely to seize the opportunity to convert their bonds into fast-growing stocks.
However, a stock price decline motivates the owner of fixed value convertible bonds. They can get more shares of stock when they make the conversion. But this process by definition increases the number of shares in the market, and that forces prices even lower.
The death spiral effect occurs as more and more fixed-value convertible bond owners convert their bonds into stocks as their value drops lower and lower.
A company that issues this type of convertible bond is probably desperate for cash to stay afloat.
Theoretically, the death spiral effect can continue until the stock is at or near zero value.
Why Create Death Spiral Debt?
This type of bond is sometimes issued by a company that desperately needs cash. A company that seeks death spiral financing probably has no other way to raise money to survive.
It is important to note that death spirals typically allow buyers to convert the bonds into shares at a fixed conversion ratio in which the buyer has a large premium. For example, a bond with a face value of $1,000 may have a convertible value of $1,500. That means a bondholder will receive $1,500 worth of shares for giving up the $1,000 bond.
However, conversion creates more shares, which dilutes the share price. This drop in price may cause more bondholders to convert because the lower share price means that they will receive more shares.
Enter the Short Sellers
Furthermore, traders short the stock in the expectation that the stock price will continue to dive.
Each additional conversion will cause more price drops as the supply of shares increases, causing the process to repeat itself as the stock's price spirals downward.
The only hope for the company to interrupt the death spiral is to improve its operational results. If it can effectively invest the proceeds of the convertible bond issue in its underlying business, it may be able to thwart the short sellers and even stick them with the losses.