Debt Restructuring: Definition, How It Works, Types & Examples

What Is Debt Restructuring?

Debt restructuring is a process used by companies, individuals, and even countries to avoid the risk of defaulting on their existing debts, such as by negotiating lower interest rates. Debt restructuring provides a less expensive alternative to bankruptcy when a debtor is in financial turmoil, and it can work to the benefit of both borrower and lender.

How Debt Restructuring Works

Some companies seek to restructure their debt when they are facing the prospect of bankruptcy. The debt restructuring process typically involves getting lenders to agree to reduce the interest rates on loans, extend the dates when the company’s liabilities are due to be paid, or both. These steps improve the company’s chances of paying back its obligations and staying in business. 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 sides because the business avoids bankruptcy and the lenders typically receive more than they would have through a bankruptcy proceeding.

The process works much the same for individuals and for nations, although on vastly different scales.

Types of Debt Restructuring

Debt restructuring for companies

Businesses have a number of tools at their disposal for restructuring their debts. One is a debt-for-equity swap. This occurs when creditors agree to cancel a portion, or all, of a company's outstanding debts in exchange for equity (part ownership) in the business. The swap is usually a preferred option when both the outstanding debt and the company's assets are significant and forcing the business to cease operations would be counterproductive. The creditors would rather take control of the distressed company, if that's necessary, as an ongoing concern.

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

A company will often issue callable bonds to protect itself from a situation in which it can't make its interest payments. 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.

In rare cases, a company can issue income bonds that promise to repay the principal only without coupon or dividend payments.

Debt restructuring for countries

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's default.

Sovereign bondholders may also have to take a haircut by agreeing to accept a reduced percentage of what they are owed, perhaps 25% of their bonds' full value. The maturity dates on bonds can also be extended, giving the government issuer more time to secure the funds it needs to repay its bondholders.

Unfortunately, this type of debt restructuring doesn't have much international oversight, even when restructuring efforts cross borders.

Debt restructuring for individuals

Individuals facing insolvency can try to renegotiate terms with their creditors and the tax authorities. For example, someone who is unable to keep making payments on a $250,000 mortgage might reach an agreement 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.

Individuals can attempt to negotiate on their own or with the help of a reputable debt relief company. This is an area that's rife with scams, so they should make sure they know whom they're involving. Investopedia publishes a regularly updated list of the best debt relief companies.