What is Debt Restructuring
Debt restructuring is a method used by companies with outstanding debt obligations to alter the terms of the debt agreements in order to achieve some advantage. Debt restructuring can also be carried out by individuals on the brink of insolvency and countries heading for default.
BREAKING DOWN Debt Restructuring
Companies raise capital by taking out loans from banks or issuing bonds to the public. Lenders, whether banks or bondholders, require compensation for lending their money in the form of interest payments. A company that has secured more than one loan could have different interest rates on these loans. The loans could also be structured in a way in which some are subordinate to other loans so that in case the company goes into bankruptcy, the senior debtholders are paid before the lenders of subordinated debt. To avoid bankruptcy, however, some companies seek to restructure their debts when in financial distress.
Debt restructuring is a process used by companies to avoid default on existing debt or to take advantage of a lower interest rate. The process is carried out by reducing the interest rates on the loans and/or extending the date when the company’s liabilities are due to be paid in order to improve the firm’s chances of paying back its loan. Creditors are made to understand that restructuring a company’s debt is in their best interest if they would receive less in a bankruptcy and liquidation event than what they would receive under a debt restructured package. Restructuring debt, therefore, could be a win-win for both entities as the business avoids bankruptcy and the lender gets something better than a bankruptcy court would give it.
In addition to the reduction of the total loan amount owed or an extension of the period of repayment, a debt restructure could also include a debt-for-equity swap. This occurs when creditors agree to cancel a portion or all of the outstanding debt in exchange for equity in the company. The swap is usually a preferred option when the debt and assets in the company are very large, and forcing it into bankruptcy will not be ideal. In these instances, the creditors would rather take control of the distressed companies as a going concern.
A company seeking to restructure its debt may also renegotiate with its bondholders to take a haircut. This typically means that a portion of the outstanding interest payments will be written off and/or a portion of the principal will not be repaid.
To protect itself from a situation where interest payments cannot be made, a company will often issue callable bonds. A bond with a callable feature can be redeemed early by the issuer, especially in times of decreasing interest rates. This allows the issuer to readily restructure debt in the future as the existing debt can be replaced with new debt at a lower interest rate.
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 may agree with the lending institution to reduce the mortgage to 75%, or 75% x $250,000 = $187,500. In return, the lender will receive 40% of the proceeds of the house sale, whenever it is sold by the mortgagor.
Countries facing default on their sovereign debt may opt to restructure their debt with bondholders. When a country undergoes debt restructuring, this could mean moving the debt from the private sector to public sector institutions, such as a central bank, which is able to better handle the impact of a country default. Sovereign bondholder may also have to take a haircut by agreeing to be paid a reduced percentage of the debt, say 25% of the full value of the bond. The maturity dates on bonds may also be extended, giving the government issuer more time to secure the funds needed to repay its bondholders.
Whether a company, individual, or country in financial turmoil, debt restructuring provides a less expensive alternative to bankruptcy as it is a process through which an entity can receive debt forgiveness and debt rescheduling, thereby, avoiding foreclosure or assets liquidation.