Debt Buybacks Research Articles

Debt Buybacks and the Myth of Creditor Power

Totaling in excess of $100 billion dollars in transactions annually, debt buybacks allow a company to repurchase bonds from investors, rewriting bargains and stripping away creditor control rights in the process. This Article shows that regulation systematically under-protects bondholders in the context of debt buybacks. It makes three points. First, bondholders confront information asymmetries that enable issuers to buy back creditor claims cheaply. Regulation imposes near negligible requirements on issuers to disclose information about the transaction. Lacking fiduciary protection, bondholder interests are vulnerable to being devalued by issuers in the interests of securing gains for shareholders and managers. Second, buybacks diminish the power of creditor control rights. Alongside information asymmetries, bondholders confront coordination costs and tight deadlines within which to evaluate a buyback and amendments to bond covenants. This pressure gives issuers incentive to underprice creditor control rights. Bondholders will not act where the gains of agitation will be less than the cost of information gathering, coordination, valuation and action. By strategically underpricing a buyback by an amount approximating these transaction costs, an issuer can pocket the difference between the price paid for the claim and that which should have been paid to bondholders for their bargain. Third, debt buybacks can allow one set of creditors (notably, banks) to extract value from bondholders. By pushing a borrower to buy back bond claims cheaply and improving the overall health of the balance sheet, banks (usually with greater individual exposure through loans) can increase their chances of being repaid. They can also acquire a more powerful voice in the borrower’s internal governance by muting that of bondholders. In concluding, this Article offers two proposals to bolster bondholder protection, advocating for greater disclosure and contractual fixes to safeguard the value of claims. With Covid-19’s devastating effects on corporate balance sheets, buybacks will assume even greater significance as firms try and restructure. These proposals help to preserve the welfare of investors in this process, protect their longer-term confidence in debt capital allocation.

The Funding Debate: Optimizing Pension Risk within a Corporate Risk Budget

Defined Benefit (DB) pension risk management has traditionally focused on achieving a balance between the risks associated with the liabilities and the expected returns on investments. This approach does not capture the fact that a DB pension plan is part of running an overall business and must compete for capital against alternative investments the corporation can make. Pension funding strategies should be assessed against other corporate cash uses and strategies, such as investment in productive capacity, research and development initiatives, share or debt buybacks, or potential acquisitions. Considering pension funding relative to potential corporate actions within the same net present value (NPV), internal rate of return (IRR) or similar analytical framework, a company can optimise the use of available cash resources and balance alternative strategies against each other.

Persuading Multiple Audiences: An Information Design Approach to Banking Regulation

A policy-maker concerned with the potential default of a bank conducts an asset quality review and a liquidity stress test under the scrutiny of multiple types of market participants (audiences). Surprisingly, the optimal comprehensive assessment is opaque when the bank has high-quality assets, and transparent when the bank has poor-quality assets. Additionally, the policy-maker imposes debt buybacks and contingent recapitalizations. I find that without the latter, disclosure of information about the bank's fundamentals may backfire. When the policy-maker lacks the technology to test the bank's private information, she designs a liquidity-provision program whereby the government offers to buy assets from the bank in exchange for cash and a public disclosure of the bank's liquidity position. Interventions display a non-monotone pecking order: the private sector funds banks with either high or poor-quality assets, while institutions with assets of intermediate quality participate in the government's liquidity program. My results shed light on the optimal way to disclose information in environments with multiple audiences and multi-dimensional fundamentals.

The Importance of Being Prudent: Leverage and the Informational Content of Dividends

This paper studies how the informational content of dividends is affected by leverage. While higher dividends convey good news at low levels of leverage, dividends become a bad signal when leverage is high. Quantitatively, a dividend increase is predicted to have a positive stock price reaction for the median public U.S. firm, but the effect is reversed at higher levels of leverage. The same switch occurs for other corporate actions, including debt buybacks, debt issuance and risk taking. The results highlight the importance of studying the various determinants of firms’ financial decisions jointly.

Sovereign Debt Maturity Under Asymmetric Information

This papers studies the optimal choice of sovereign debt maturity when investors are unaware of the government’s willingness to repay. Under a pooling equilibrium there is a wedge between the borrower’s true default risk and the default risk priced in debt, and the size of this wedge differs with the maturity of debt. Long-term debt becomes less attractive for safe borrowers since it pools more default risk that is not inherent to them. In response, safe borrowers issue low levels of debt with a shorter maturity profile – relative to the optimal choice under perfect information – and risky borrowers mimic the behavior of safe borrowers to preclude the market from identifying their type. In times of financial distress, the default risk wedge of long-term debt relative to short-term debt increases which makes borrowers reduce the amount of debt issuance and shorten its maturity profile, a fact that is observed among emerging economies. Under this framework, debt buybacks can be optimal when there is an overestimation of the country’s risk perception in the market that was not present when long-term debt decisions were made.

Tax Issues in Consensual Debt Restructuring

The authors present the main Dutch tax aspects of consensual debt restructurings involving Dutch debtors, including consensual debt restructurings by means of amendments of the terms and conditions of debt, debt buy-backs, debt-for-debt or debt-for-equity swaps, and debt waivers.

Tax Avoidance on Debt Buy-Backs and Authorized Investment Funds

Recent changes to legislation have closed two tax avoidance arrangements involving debt buy-backs and authorized investment fund income. This article describes the measures put in place to deal with the tax avoidance arrangements, but discusses debt buy-backs in more detail, as the measures could potentially affect transactions whose main purpose is not tax avoidance.

Sovereign debt portfolios: risks and liability management operations

This paper addresses issues relating to (1) sovereign debt portfolio risks stemming from high sovereign debt levels and unbalanced debt portfolio structures, and (2) liability management operations intended to meet specified debt management objectives, including mitigation of these risks. Further, it outlines some common operations used by public debt managers such as debt swaps and debt buybacks, and explains the rationale and benefits from their undertakings.

Restoring Financial Stability in the Euro Area

The pricing of sovereign credit risk is a necessary component of the financial architecture of the European Monetary Union. However, unnecessarily high and volatile risk premia on government bonds are currently preventing effective financial intermediation within the euro area, thereby inhibiting its economic recovery. Several proposals have been made on how these risk premia should be brought down, namely i) permanent pooling of funding through joint bond issuance, ii) temporary liquidity assistance through multilateral funds, iii) debt buybacks using multilateral funds, and iv) debt restructuring. This paper attempts to evaluate these four proposals. It argues that joint bond issuance will not achieve a meaningful reduction of liquidity premia in the sovereign bond market; these instruments would either create perverse incentives or accelerate the sovereign debt crisis for peripheral Europe. An institution to provide temporary liquidity assistance is a necessary addition to the institutional framework of EMU – there needs to be an EMF to complement the ECB. Debt buybacks using multilateral funds can be a very useful tool for solvent countries such as Spain; they can prevent an overshooting of risk premia that could turn a sovereign liquidity crisis into a solvency crisis. A quantitative assessment shows that debt buybacks at market prices are insufficient to correct Greece’s debt overhang, however. In the case of Greece, a voluntary exchange of existing government bonds into new obligations, complemented by a buyback option at a steep discount to face value, could restore sovereign creditworthiness and allow the private sector to regain market access at acceptable interest rates. In the absence of such an orderly and controlled reduction of public debt, highly indebted euro area governments will likely opt to restructure their sovereign debt unilaterally, if they fail to regain market access after several years. This could have unwelcome consequences for financial stability in the euro area, which should be avoided through a creative and cooperative approach to the problem.

A note on the effects of debt buybacks in the MM world

This study notes that in the world of Modigliani and Miller (MM), a debt buyback program will maximize the share price as well as cash flows to the stockholders. Also, holding period returns for investors that buy into the company before the debt buyback are higher than a similar MM firm that does not repurchase its debt.

DEFAULT COSTS, WILLINGNESS TO PAY, AND SOVEREIGN DEBT BUYBACKS

The arguments put forward by Bulow and Rogoff [Brookings Papers on Economic Activity, 2 (1988) 675; Quarterly Journal of Economics, 106 (1991) 1219] against sovereign debt buybacks are re-examined in a willingness-to-pay framework. This paper argues that the Bulow–Rogoff framework treats default by a debtor as an event with no dead-weight loss, and, as such, underestimates the potential gains from a buyback. The willingness-to-pay framework allows dead-weight costs of default to be introduced in a consistent and simple fashion into the buybacks calculus. Two versions of this framework are considered. First, a model in which the default costs induce an all-or-nothing default decision is analyzed. In this case, an ambiguous result is derived in which the variability of the debtor's income determines whether (small) buybacks are beneficial to the debtor, even though expected total transfers to the creditor increase, consistent with Bulow–Rogoff. In a second version, default costs are modeled so as to induce at most a partial default. This model corresponds most closely, in terms of the repayment behavior of the sovereign debtor, to the models used by Bulow and Rogoff. It is shown that small buybacks are always beneficial to the debtor in this case. The second version is extended to include an investment opportunity. Only if the country has sufficiently scarce resources when the investment can be made will a buyback be harmful to the interests of the debtor.

Sovereign Debt Buybacks: International and Domestic

Since the 1980s many indebted countries have repurchased part of their debt usually at substantial discounts on the face value and these operations have appeared to be an attractive opportunity for highly indebted countries. Since 1990 onwards, some OECD countries have also begun to acquire experience in the use of debt repurchase instruments and some of them established regular bond repurchasing programmes. As far as we know, the literature on public debt management has not dealt with buybacks of domestic debt (except, for example, Coe et al., 2000), while they have been analysed quite deeply in the international debt framework. The main objectives of a domestic debt repurchase is to reduce both the risks and the costs of debt service. The risk that is considered is refinancing risk. Through buybacks the government can intervene in the market in order to smooth the maturities profile and so to avoid tensions in the secondary market. Then, buybacks could help reducing the costs of indebtedness for three reasons. In the first place they could be a way to increase the liquidity of the secondary market by switching from illiquid to liquid securities. A second way to reduce the costs of debt service could also derive from an opportunistic use of repurchases. The government could distinguish the more expensive bonds in the market and repurchase them issuing in their place cheaper securities. Finally, buybacks could be used to eliminate unfair risk premium since they can be used by a government in order to enhance its commitment to an announced policy.

The 1994 Brazilian Debt Renegotiation: A Cure for Overhang?

There is an argument in the literature that open-market sovereign debt repurchases are not beneficial for the debtor country, even if they can alleviate debt overhang. This paper shows that debt buybacks can actually lead to a worsening of the debt overhang problem. This is possible if the real return on investment in the debtor country is sufficiently high, so that resources used to finance the buyback have a high opportunity cost, and the debt reduction is small compared to the amount of resources allocated to the repurchase. In 1994 the Brazilian government restructured its external debt financing package as part of the Brady plan initiative. The Brady plan was an attempt for severely indebted countries to achieve a debt reduction at a price lower than the one through secondary market buybacks, and therefore retaining some of the (possible) efficiency gains. Using open-market buybacks as benchmark, bounds for possible gains from the deal are calculated, and an assessment is made in respect to whether the deal helped alleviating the debt overhang problem.

Debt Buybacks, Debt Reduction, and Debt Rescheduling under Asymmetric Information

In the early nineties there was a significant recovery of many debtridden economies after the shift in debt policy implicit in the socalled Brady Plan. Yet, the use of scarce resources from debtor countries to buy back part of their debts remains a controversial feature of this Plan. We use a multiperiod model of debt overhang to show that, under asymmetric information, this transfer of resources emerges naturally as part of the shift from a strategy of debt rescheduling, to one of debt reduction. AFTER NEARLY A DECADE OF SUFFERING from debt-ridden economies, in the early nineties many countries with large external debts finally reduced their debt-service ratios, regained access to spontaneous private financing and achieved higher growth and lower inflation (IMF 1993). Many analysts have since attributed at least part of this success to the shift in the international debt strategy in 1989 which took a new direction with the so-called Brady initiative.l A rather controversial feature of this initiative was the use of scarce resources from the debtor countries to buy back part of their debt. There are two reasons why this use of a country's resources seems unwise. First, capital has more value in the debtor country than abroad. Thus, transferring additional current resources from the country to its creditors at fair prices would appear to be welfare reducing. Second, contrary to the idea that by repurchasing its debt in the open market a debtor country benefits from the discount price, Bulow and Rogoff (1988, 1991) prove under assumptions that include symmetric information that these buybacks hurt the country, since the purchase price2 incorporates (and transfers to the seller) all the benefits caused by a reduced debt.3

Gifts and Debt Buy‐Backs

Gifts and Debt Buy‐Backs

Organized debt buybacks: No cure for free riding?

This paper discusses the possibility of resolving the international debt overhang problem through an ‘organized buyback’ at the secondary market prices suggested by Peter Kenen. We focus on one aspect of the feasibility: the elimination of the free-rider problem of creditors in the presence of the secondary market for sovereign debt. The analysis shows that there are equilibria in which the ‘organized buyback’ can be blocked by the free riding among banks.

Sensible buybacks of sovereign debt

Sovereign debt is not prioritized, and creditors share the costs of a default in proportion to their exposure. Equal-sharing insures that all creditors cooperate in imposing default sanctions, but it leads to excessive borrowing. Countries that borrowed too much because of equal-sharing can gain from debt buybacks, even if there is no debt overhang. Sensible buybacks should be accompanied by either an interest rate reduction or a new money provision, they should grant unsold debt seniority over new loans, and they should assign future debt renegotiation to a third party.

Debt Buybacks Signal Sovereign Countries' Creditworthiness: Theory and Tests

The authors show that debt buybacks could convey valuable information about indebted countries' willingness to invest and increase debt repayment when creditors are less informed than debtors. In an informational equilibrium, unwilling countries do not repurchase a part of their debt, but willing countries do; and creditors increase debt repayments by offering reliefs only to those countries that repurchase. Data show that creditors systematically grant debt reliefs only to countries with buyback programs; and a country's secondary market debt price is higher when it has a buyback program than if it does not. Copyright 1993 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Sovereign Debt: A Primer

The troublesome debts of many developing countries have spawned much literature on why countries borrow, on what debt contributes to growth, on why countries repay, and on how to deal with existing debt. The author provides an analytical primer on the following aspects of sovereign debt : 1) the basic accounting concepts associated with debt and some data associated with external borrowing; 2) debt as a component of an optimizing model of borrowing in a competitive loan market, when the borrower faces an intertemporal budget constraint; 3) debt as a component of recent models of endogenous growth; 4) problems arising from sovereign risk, including problems of liquidity, enforcement, and revenue-raising to finance repayment; 5) incentives to repay; 6) options available to a creditor whose debtor is unwilling to meet current debt-service obligations; and 7) debt buybacks. The author concludes that in the absence of any efficiency cost imposed by outstanding debt, how much a buyback benefits the borrower depends on how much buying back debt reduces what is available for repayment later. The author also concludes that if there are efficiency losses associated with debt, debt forgiveness can benefit both a debtor nation and its creditors. Contrary to claims in the literature, this outcome does not require that a reduction in the face value of debt raise its market value, and the debtor benefits even though the buyback raises the market price of the debt.

Debt Buybacks and Forgiveness in a Model with Voluntary Repudiation

Debt reduction is usually analyzed in models where default is involuntary and the gains from debt reduction derive from various disincentives linked to a large debt overhang. This paper uses a model in which default is voluntary and shows that debt reduction can be beneficial even in the absence of those disincentives, by inducing debtors to renounce or postpone repudiation. This is likely to happen when debts are large compared to the penalties incurred by debtors if they repudiate. Furthermore, debtors can gain from debt buybacks even after allowing fully for the opportunity costs of using reserves for that purpose. [430]