What Is Debt Restructuring?

Debt restructuring is a process used by companies to avoid the risk of default on existing debt or to take advantage of lower available interest rates. Debt restructuring can be carried out by individuals on the brink of insolvency as well, and by countries that are heading for default on sovereign debt.

Key Takeaways

  • The debt restructuring process can be carried out by reducing the interest rates on loans or by extending the dates when a company’s liabilities are due.
  • A debt restructure might include a debt-for-equity swap, when creditors agree to cancel a portion or all of the outstanding debt in exchange for equity in the company.
  • A nation seeking to restructure its debt might move its debt from the private sector to public sector institutions.

How Debt Restructuring Works

Some companies seek to restructure debts when they're facing bankruptcy. They might have several loans are structured in such a way that some are subordinate in priority to other loans. The senior debtholders would be paid before the lenders of subordinated debts if the company were to go into bankruptcy. Creditors are sometimes willing to alter these and other terms to avoid dealing with a potential bankruptcy or default.

The debt restructuring process is typically carried out by reducing the interest rates on loans, by extending the dates when the company’s liabilities are due to be paid, or both. These steps improve the firm’s chances of paying back the obligations. Creditors understand that they would receive even less should the company be forced into bankruptcy and/or liquidation.

Restructuring debt can be a win-win for both entities. The business avoids bankruptcy and the lenders typically receive more than what they would through a bankruptcy proceeding.

Individuals can restructure their debts in various ways as well, but be sure to check the credentials and reputation of any debt relief service you're considering with your state's attorney general or consumer protection agency because not all are reputable.

Types of Debt Restructuring

A debt restructure might also include a debt-for-equity swap. This occurs when creditors agree to cancel a portion or all of their outstanding debts in exchange for equity in the company. The swap is usually a preferred option when the debt and assets in the company are very significant, so forcing it into bankruptcy would not be ideal. The creditors would rather take control of the distressed company as a going concern.

A company seeking to restructure its debt might also renegotiate with its bondholders to "take a haircut"—where a portion of the outstanding interest payments would be written off, or a portion of the principal will not be repaid.

A company will often issue callable bonds to protect itself from a situation in which interest payments cannot be made. A bond with a callable feature can be redeemed early by the issuer in times of decreasing interest rates. This allows the issuer to readily restructure debt in the future because the existing debt can be replaced with new debt at a lower interest rate.

Other Examples of Debt Restructuring

Individuals facing insolvency can renegotiate terms with creditors and tax authorities. For example, an individual who is unable to keep making payments on a $250,000 subprime mortgage might agree with the lending institution to reduce the mortgage to 75%, or $187,500 (75% x $250,000 = $187,500). In return, the lender might receive 40% of the proceeds of the house sale when it's sold by the mortgagor.

Countries can face default on their sovereign debt, and this has been the case throughout history. In modern times, they sometimes opt to restructure their debt with bondholders. This can mean moving the debt from the private sector to public sector institutions that might be better able to handle the impact of a country default.

Sovereign bondholders might also have to "take a haircut" by agreeing to accept a reduced percentage of the debt, perhaps 25% of the full value of the bond. The maturity dates on bonds can also be extended, giving the government issuer more time to secure the funds needed to repay its bondholders. Unfortunately, this type of debt restructuring doesn't have much in the way international oversight, even when restructuring efforts cross borders.

Debt restructuring provides a less expensive alternative to bankruptcy when a company, individual, or country is in financial turmoil. It's a process through which an entity can receive debt forgiveness and debt rescheduling to avoid foreclosure or liquidation of assets.