What Is Death Spiral Debt?
Death spiral debt describes debt financed through the use of a certain type of convertible bonds or convertible preferred stock resulting in an ever-increasing number of shares of common stock, inevitably leading to a steep drop in the price of those shares. Ultimately bankruptcy can result.
In general, convertible debt yields interest or dividends but also can be converted to common stock shares. Both types of debt are hybrid securities with attributes of both bonds and stocks.
- Death spiral debt refers to debt that can be converted to common shares, increasing the number of common shares and diluting the stock price of those shares.
- The type of bond or security that can cause the death spiral effect converts to predetermined value instead of a set number of shares of common stock.
- The more these instruments are converted, the more shares are created and the lower the share price will go.
- Ultimately a death spiral results and the company can be forced into bankruptcy.
Understanding Death Spiral Debt
A conventional convertible bond or preferred stock can be converted to a fixed number of shares. Death spiral debt, however, converts into a fixed value paid in shares.
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 or shares. They can get more shares of stock when they make the conversion. 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 instrument owners convert their holdings into common stock 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 debt 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.
Bed Bath and Beyond
Retail chain Bed Bath and Beyond represents an example of potential death spiral debt if the struggling company's recent issue of $225 million in convertible preferred stock plus warrants for an additional $800 million over time ultimately results in bankruptcy.
It is important to note that death spirals typically allow buyers to convert the bonds or stock into common shares at a fixed value (not ratio). For example, a bond with a face value of $1,000 may have a conversion amount of $1,500. That means a bondholder will receive $1,500 worth of common shares by giving up a $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.