Premium debt swaps: the best of both worlds?

Financial Management (Financial Management Association), Autumn, 1998 by Andrew Kalotay, Leslie Abreo

January 1998 saw the introduction of a new type of debt-for-debt exchange - par-for-par swaps involving bonds selling at a substantial premium. Using this approach, two major transactions took place: the $700 million United Parcel Service 8 3/8's of 2020 and the $200 million Freddie Mac 8 1/4's of 2016. Then, in February, Banc One made an exchange offer for its 9 7/8's of 2009, a $200 million issue. These transactions represent a new trend in debt management.

The challenge of effective corporate debt management lies in the complex interaction of cash flow and accounting considerations. It is often the case that when a transaction is desirable from an accounting perspective, the tax treatment tends to be unfavorable. On the other hand, when the cash flows are attractive, the accounting may be unpalatable. The retirement of outstanding debt stands as a case in point.

During periods of low interest rates, the repurchase of debt selling at a premium tends to have a positive net present value. However, the premium paid over face value must be recognized as an immediate loss for accounting purposes. The accounting impact can be substantial - repurchasing $100 million face value of bonds at a price of 105, for instance, results in a $5 million reduction in pretax earnings. Bearing in mind that the compensation of top management is often tied to the corporation's earnings, it is not hard to understand why high-coupon bonds callable at a premium are sometimes left outstanding far beyond when they should be redeemed.

On the other hand, when interest rates are relatively high, the repurchase of discounted debt prior to maturity may seem attractive, but only until one realizes that the associated gain is taxable. For example, if the corporation's marginal tax rate is 40%, the after-tax cost of repurchasing a bond at a price of 60 turns out to be 76.

So, the debt-refunding challenge is two-pronged. If the cash flows are desirable, how should the transaction be structured so that its accounting is acceptable? Or, if the accounting is desirable, how should the tax burden be alleviated?

In major investment banks where innovation is the driving force behind business development, debt management has been fertile ground for new ideas in the last several decades. Teams of financial analysts, tax attorneys, and accountants spend long hours working on such problems. Although the novel financial structures and transactions emanating from such efforts cannot be patented, the payoff in fees and prestige is often substantial.

Not surprisingly, the Financial Accounting Standards Board and, more so, the Internal Revenue Service tend to be on the opposing side of these creatively structured transactions. Consequently, innovation by investment banks is often followed in quick succession by changes in accounting practices or tax regulations.

I. A Brief History of Debt Swaps

Although the type of debt exchange under discussion involves bonds selling at a premium, it is important to appreciate that the events leading up to it involved discount, rather than premium, bonds. During periods of high interest rates, as was the case in 1981 when long Treasuries hovered around 15%, the issuers naturally considered repurchasing/extinguishing obligations at deep discounts. But, as mentioned earlier, even if such repurchases would boost earnings, the immediate taxation of the resulting gain would make them prohibitively expensive.

On the other hand, if taxation of the gain could be avoided, extinguishing discounted debt would be desirable from both a cash flow and an accounting perspective (see Kalotay, 1978). In 1981, this was accomplished in large volumes through equity-for-debt swaps. Equity-for-debt swaps were treated as nontaxable recapitalizations, until the Tax Reform Act of 1984 made such exchanges taxable (see Finnerty, 1987).

Par-for-par debt swaps, on the other hand, remained nontaxable until the 1990 Omnibus Budget Reconciliation Act, which was motivated by some sizable swaps earlier that year (see Kalotay and Tuckman, 1992). So, par-for-par swaps no longer make sense for discount debt, but, as we shall see, from a tax angle they are fine for premium debt.

II. The UPS Premium Debt Swap

The UPS exchange, which we will use as an illustrative example in this paper, fits this criterion. It is a par-for-par swap for option-free debt that was selling at a substantial premium. The maturity of the new debentures is somewhat longer than that of the outstanding ones, and, in order to be acceptable to investors, their value is marginally higher.

In January 1998, the estimated value of the UPS 8 3/8's of 2020 was 123.76%. The debentures offered in exchange have a 2030 maturity, their coupon remains 8 3/8% until 2020, and from 2020 until maturity it will step down to 7.62%. Because this "extension coupon" is still above the forward ten-year rate as of 2020, the value of the new bonds at the time of the exchange was about a point higher, or 124.77%.

From the investor's perspective, the transaction is straightforward. The investor receives a new bond whose value is approximately one point higher than the outstanding one. If the investor is a non-taxable institution, such as a pension fund, tax considerations are not relevant. But some taxable bonds may be held by tax-paying insurance companies. In any case, according to the UPS prospectus, under current tax treatment, a par-for-par debt exchange is not a taxable event for the investor.