What is debt restructuring?
Debt restructuring is a process used by companies to avoid the risk of defaulting on existing debt or to take advantage of lower available interest rates. Debt restructuring can also be done by individuals on the verge of insolvency and by countries that turn to default on sovereign debt.
Key points to remember
- The debt restructuring process can be achieved by lowering interest rates on loans or by extending the due dates of a company’s liabilities.
- Debt restructuring can include an exchange of debt for equity when the creditors agree to cancel some or all of the outstanding debt in exchange for equity in the company.
- A country seeking to restructure its debt could shift its debt from the private sector to public sector institutions.
How Debt Restructuring Works
Some companies seek to restructure their debts in the event of bankruptcy. They may have several loans structured so that some are subordinated in priority to other loans. The principal creditors would be paid before the lenders of subordinated debt if the company were to go bankrupt. Creditors are sometimes willing to modify these and other conditions to avoid facing bankruptcy or potential default.
The debt restructuring process is generally accomplished by reducing interest rates on loans, extending the dates by which the company’s liabilities are due, or both. These steps improve the company’s chances of paying off its bonds. Creditors understand that they would receive even less if the business were to go bankrupt and / or go into liquidation.
Debt restructuring can be beneficial to both entities. The company avoids bankruptcy and lenders generally receive more than they would receive in bankruptcy proceedings.
Individuals can also restructure their debts in a variety of ways, but be sure to check the credentials and reputation of any debt relief service you are considering with your state’s attorney general or protection agency consumers, because not all are famous.
Types of debt restructuring
Debt restructuring could also include an exchange of debt for stocks. This happens when the creditors agree to cancel some or all of their outstanding debts in exchange for equity in the company. The swap is generally a preferred option when the debt and assets of the business are very large, so forcing it into bankruptcy would not be ideal. Creditors would prefer to take control of the distressed company as a business in operation.
A company seeking to restructure its debt could also renegotiate with its bondholders to “take a haircut” – where part of the outstanding interest would be written off or part of the capital would not be repaid.
A business will often issue redeemable bonds to protect against a situation in which interest payments cannot be made. A bond with a redeemable characteristic can be redeemed early by the issuer during periods of falling interest rates. This allows the issuer to easily restructure its debt in the future, since the existing debt can be replaced by new debt at a lower interest rate.
Other examples of debt restructuring
Persons facing insolvency can renegotiate the terms with creditors and tax authorities. For example, a person who is unable to continue making payments on a subprime mortgage of $ 250,000 may agree with the lending institution to reduce the mortgage to 75%, or $ 187,500 (75% x $ 250,000 = $ 187,500). In return, the lender could receive 40% of the proceeds from the sale of a home when it is sold by the mortgagee.
Countries can default on their sovereign debt, and this has been the case throughout history. In modern times, they sometimes choose to restructure their debt with bondholders. This may mean shifting debt from the private sector to public sector institutions that could better manage the impact of a country’s default.
Holders of sovereign bonds may also have to “cut their hair” by agreeing to accept a reduced percentage of debt, perhaps 25% of the total value of the bond. Bond maturity dates can also be extended, giving the public issuer more time to secure the funds needed to repay its bondholders. Unfortunately, this type of debt restructuring has little to do with international surveillance, even when restructuring efforts cross borders.
Debt restructuring offers a cheaper alternative to bankruptcy when a business, individual or country is in financial trouble. It is a process by which an entity can benefit from debt forgiveness and debt rescheduling to avoid foreclosure or liquidation of assets.