Coercive Bond Exchange Offers

Most bonds include contract provisions by which covenants can be changed. These provisions are usually difficult to change, except in financial distress. For the most part, firms must live with whatever covenants they write up front.

But there is one mechanism that sometimes allows creditors to take advantage of public bondholders and that you should be aware of: the exchange offer. These days, they are rare, because creditors have learned to protect themselves against such "offers." Still, the basics of the mechanism is worth knowing.

Consider a firm worth $500, which had earlier sold one type of bond with a face value of $1,000 to 100 creditors. Each bond is a claim on $10, and it is now really worth only $5. How can managers reduce the face value of the claim, so that an increase of less than $500 would allow the equity to be back in the money again? The answer is an exchange offer. For example, if you offer each creditor a higher-seniority (or shorter term) bond for only a claim of $6 (a total of $600), it would not be, collectively, a good exchange for them. But consider what is in the interest of each creditor.

• If no other creditor accepts the exchange offer, then an unexchanged $10 bond is worth only $5. If one creditor accepts the exchange bond, it is paid first, so its value increases from $5 to $6.

• If the remaining 99 creditors all accept the exchange offer, then an unexchanged $10 bond would be worth nothing. The new bonds would collectively claim 99 ■ $6 = $594 of the firm—and with only $500 in value, nothing would be left for an original, unexchanged, and thus lower-priority bond.

It is in the interest of every bondholder to participate, but that means they will collectively end up worse off. Thus, the bond exchange offer works only if the firm can play off its creditors against one another—it does not work if one single creditor (a bank) holds the entire bond issue. To eliminate such coercive bond exchange offers, many bond covenants now require firms to first obtain approval by majority or super-majority vote before a bond can be exchanged or a covenant be waived. In this case, every bondholder would vote against the exchange offer, and thereby come out better off.

Most of the time, covenants are firm.

But there is one occasional exception, which appears if creditors are "underwater."

How to "swindle" the bondholders.

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