There are several possible ways in which a debt swap can be done. However, the aim is usually the same – to refinance a borrower and strengthen its balance sheet.
So, for example, if a large bank such as Anglo Irish gets into financial difficulty, a deal can be done in such a way that holders of high-risk ‘subordinated’ bonds are offered the chance to swap them for much lower-risk, government-backed securities. For the investor, the scheme offers the chance to get out of an investment that may never pay back future coupons and/or capital.
However, under the swap, they can expect to receive a much smaller value of the safer debt in return for existing riskier holdings. The borrower gets to book the difference between those two values as an accounting gain. That in turn strengthens its balance sheet and may improve its regulatory capital ratios.
• See Tim Bennett’s video tutorial: What is a balance sheet?