From August 1981 to April 1983, nearly 200 firms completed stock-for-debt swaps. There are two ostensible motivations for such a swap—increased earnings and reduced leverage. Although the swaps did boost reported earnings, leverage reduction was not material. Furthermore, an analysis of share price performance on the swap announcement dates indicates that returns for the portfolio of swapping firms were significantly negative; the market did not capitalize “financial statement improvements.”
A more reasonable motivation for stock-for-debt swaps is the effect of the Bankruptcy Tax Act of 1980 on sinking fund management. Before 1981, companies that purchased bonds at a discount to fulfill sinking fund requirements incurred essentially no tax liability. Since the effective date of the Act, however, these same sinking fund cash purchases of discount bonds generate a significant tax liability. By using a swap instead of purchasing the bonds with cash, companies can accomplish the transactions on a tax-free basis.
The significant negative stock returns observed around swap dates may be due to the presence of accumulators in the sinking fund bond market; if accumulators “corner the market” in the floating supply of bonds, they can force issuers to pay premium prices for their bonds.