What Is Debt Restructuring?

Debt restructuring is a process used by companies to avoid the risk of default on existing debt or lower available interest rates. Individuals on the brink of insolvency also restructure their debt as do countries that are heading for a default on sovereign debt.

Key Takeaways:

  • The debt restructuring process can reduce the interest rates on loans or extend the due dates for a company’s liabilities.
  • A debt restructure might include a debt-for-equity swap, in which creditors agree to cancel a portion or all of the outstanding debt in exchange for equity.
  • 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 their debt when they are facing bankruptcy. A company might restructure several loans so that some are subordinate in priority to other loans. Senior debtholders are paid before the lenders of subordinated debts if the company files for bankruptcy. Creditors are sometimes willing to alter debt terms to avoid potential bankruptcy or default.

The debt restructuring process typically involves reducing the interest rates on loans, 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 or liquidation.

Debt restructuring can be a win-win for both entities because the business avoids bankruptcy, and the lenders typically receive more than what they would through a bankruptcy proceeding.

Individuals, as well as businesses, can restructure their debt. However, they should first check the credentials and reputation of any debt relief service they are considering using with their 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. The swap is usually a preferred option when the debt and assets are significant and 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," in which 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 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 house sale proceeds when it is sold by the mortgagor.

Countries can face default on their sovereign debt, and this has been the case throughout history. In modern times, some countries 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 bond's full value. 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 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 is a process through which an entity can receive debt forgiveness and debt rescheduling to avoid foreclosure or asset liquidation.