What is a Debt/Equity Swap

A debt/equity swap is a transaction in which the obligations or debts of a company or individual are exchanged for something of value, equity. In the case of a publicly traded company, this generally entails an exchange of bonds for stock. The value of the stocks and bonds being exchanged is typically determined by the market at the time of the swap.

BREAKING DOWN Debt/Equity Swap

A debt/equity swap is a refinancing deal in which a debt holder gets an equity position in exchange for cancellation of the debt. The swap is generally done to help a struggling company continue to operate. The logic behind this is an insolvent company cannot pay its debts or improve its equity standing. However, sometimes a company may simply wish to take advantage of favorable market conditions. Covenants in the bond indenture may prevent a swap from happening without consent.

Why Use Debt/Equity Swaps?

Debt/equity swaps can offer its debt holders equity because the business does not want to or cannot pay the face value of the bonds it has issued. To delay repayment, it offers stock instead.

In other cases, businesses have to maintain certain debt/equity ratios, and inviting debt holders to swap their debts for equity if the company helps to adjust that balance. These debt/equity ratios are often part of financing requirements imposed by lenders. In other cases, businesses use debt/equity swaps as part of their bankruptcy restructuring.

Debt/Equity and Bankruptcy

If a company decides to declare bankruptcy, it has a choice between Chapter 7 and Chapter 11. Under Chapter 7, all of the business' debts are eliminated, and the business no longer operates. Under Chapter 11, the business continues its operations while restructuring its finances. In many cases, Chapter 11 reorganization cancels the company's existing equity shares. It then reissues new shares to the debt holders, and the bondholders and creditors become the new shareholders in the company.

Debt/Equity Swaps vs. Equity/Debt Swaps

An equity/debt swap is the opposite of a debt/equity swap. Instead of trading debt for equity, shareholders swap equity for debt. Essentially, they exchange stocks for bonds.

Justifying Debt/Equity Swaps

In cases of bankruptcy, the debt holder does not have a choice about whether he wants to make the debt/equity swap. However, in other cases, he may have a choice in the matter. To entice people into debt/equity swaps, businesses often offer advantageous trade ratios. For example, if the business offers a 1:1 swap ratio, the bondholder receives stocks worth exactly the same amount as his bonds, not a particularly advantageous trade. However, if the company offers a 1:2 ratio, the bondholder receives stocks valued at twice as much as his bonds, making the trade more enticing.