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Creditors get bumped down the ranks
Say a company offers $80 million of new debt to holders of $100 million of its existing bonds. The new debt matures three or four years later, pays a higher interest rate, and sits in a superior position in the capital structure. The holders accept 80 cents on the dollar in exchange for that position and that higher return.
The company gets its maturity pushed out. The holders now own the debt of a much riskier company than the one they first invested in, and that company could not have gone to the open market and raised new debt on similar terms. It would be way too expensive.
For everyone else, the exchange reshuffles who ranks where. It is like arriving at a wedding expecting the captain's table with the bride and groom, and finding yourself at the kids' table with the nine-year-old niece and nephew.
Why accept 80 cents for a dollar?
Holders trade face value for priority and a higher coupon. Senior claims recover more in bankruptcy than junior ones, so a smaller claim ranked higher can be worth more. The new debt also pays more interest on the amount held. Holders weigh that against the risk of holding old debt that may be paid nothing.
How does a new senior claim hurt others?
Collateral can only be sold once. If new debt ranks ahead on the same collateral, it must be repaid before older claims receive anything from it. The older holders' expected recovery therefore falls. Lawyers sometimes call this priming.
Why exchange bonds instead of selling new ones?
A distressed company often cannot borrow at affordable rates in the open market. An exchange offer lets it work with its existing holders, who already know the business. S&P Global Ratings treats a distressed exchange as a default, even if no payment is missed. The company's rating is lowered to selective default at that point.
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