Debt Conversion

DEBT CONVERSION. Conversion is the term applied to the exchange of any form of security for another form of security. Though the exchange is usually connected with a decrease in cost to the borrower of the security in question, this is not always the case. It is sometimes necessary, more particularly in time of war when a series of loan operations is probable, to assure subscribers to an earlier issue that they will be entitled to "convert" it to any later issue made on more favourable terms. Such a provision was a common feature of British war loans, for instance, holders of 3 % War Loan were entitled to convert into 5% War Loan, and holders of National War Bonds of the first three series re tained a right to convert at any time on favourable terms into 5% War Loan. Similarly in the United States holders of the 31 % First Liberty Loan were entitled to convert into the 4% Second Liberty Loan and holders of the Second Liberty Loan into the 41% Third Liberty Loan.

But the more frequent and more interesting cases of conver sion arise in connection with debt reduction. Public debt, other than the relatively limited amount created for revenue producing purposes, usually results from a period of financial emergency in which revenue has not covered expenditure and the State has ac cordingly had to pledge its credit in circumstances least favour able to itself. It has, therefore, always been the natural object of financial statesmanship, as soon as normal financial conditions return, to reduce the burden of debts created under duress— after an earthquake, a famine or a war. This course is dictated by the consideration that ex hypothesi, the debt is raised at a price higher than the credit of the State in normal circumstances would justify. It is also desirable because as a rule the great public debts such as war debts, justified and even inevitable as they may have been, do not leave behind them any concrete object from which posterity can see that it draws tangible benefit.

Methods of Debt Reduction.

The burden of debt may be reduced in various technically distinguishable ways. In the first place, debt may be redeemed either out of budget surpluses (in Great Britain called "old sinking fund") or out of a sinking fund provided within the normal budget (in Great Britain called "new sinking fund"), these resources being applied either to paying off debt as it falls due or to the purchase of public stock or bonds on the Stock Exchange at current market prices or, where the loan contract so permits, to drawings of individual bonds by lot for payment at a fixed price, usually not necessarily at par. These latter redemptions can be effected irrespective of the date on which the debt holder is entitled to claim repayment from the State as a right. In the second place, maturing debt, that is to say, debt for which the repayment date as fixed by the loan contract has arrived, may be repaid out of money raised by new borrowing on more favourable terms. This operation, which is properly a form of redemption, is frequently, though inaccurately, described as conversion. In the third place holders of the debt which has not yet reached its maturity date may be persuaded to exchange their holdings into some other form of debt. This is debt conver sion proper, its essential feature being the exchange of one obliga tion for another. Conversion is normally a voluntary process. Forced conversion, such as for instance the Italian "Lictor" Loan of 1926, is a practical operation in certain cases. Whether it is a wise operation depends on such factors as the financial position and traditions of the country concerned; the nature of the crisis with which it is faced; and its probable needs for further credit. Obvi ously, when a particular class of persons have lent money to the community on agreed contractual terms, it requires very ex ceptional circumstances to justify subsequent compulsion to accept other terms presumably less advantageous to themselves.

These three methods of debt reduction are frequently prac tised in combination. Indeed, with a large volume of debt no one of them can be successful in isolation ; each contributes to, and is a condition of, the success of the others. Large revenue surpluses applied to debt redemption in Great Britain and the United States of America in the years immediately following 1918 were the essential preliminary to that appreciation of the national credit of the two countries which caused their public securities to rise in price and consequently enabled the two Treasuries to replace old debt by new debt on cheaper interest terms. Where the total debt is large, the maintenance of a substantial sinking fund pro vided out of revenue is primarily required for this purpose. A re duction in the supply of any commodity tends to intensify the demand for that commodity and thus to increase the price which the seller can obtain. A reduction in the volume of debt has pre cisely the same effect. The borrowing Government can sell its wares at a better price by reducing the amount in supply. A sink ing fund which removes stock or bonds from the market and cancels them enhances the price of what remains and enables ma turing debt in excess of what can actually be paid off to be re placed at a lower interest rate. Similarly, the reduction in the volume and the increase in the value of Government securities enables conversion schemes to be launched with success.

It is futile to single out any one method of debt reduction as a success or a failure. The general result usually flows from the combined use of all methods; and the attribution of specific por tions of that result to any single method tends to be misleading. Redemption and conversion go together. Thus, in Great Britain the interest charge for the debt was reduced by £ 19,000,000 per annum in the period between 1920-21 and 1925-26. If, to com pare like with like, allowance is made for the fact that in the former year only £ 289,000 was paid on the debt due to the United States Government while in 1925-26 the full interest charge of over £28,000,000 was paid, the real reduction in interest charge is seen to be more than £47,000,000 per annum. Of this reduc tion it may be said that £29,500,000 was due to the repayment of debt from revenue; £ 16,000,00o to the replacement of short-term floating debt by cheaper floating debt; and L1,500,000 to strictly identifiable long-term conversions. It is, however, impossible to say what would have been the result of any one of these three methods without the concomitant of the other two.

Conditions of Conversion.

It is usually held that for suc cessful conversion certain preliminary conditions must be fulfilled. The problem is to persuade the holder of a given security that it is in his interest to accept instead another security subject to different terms as regards interest, redemption date and possibly other privileges. The holder will probably be affected in the first place by his belief in the political stability of the borrowing Gov ernment. He will not wish to extend in time his commitment to a State which is politically insecure or which for any reason is likely in the visible feature to depreciate its credit. He will re quire to be convinced that his new commitment if he accepts con version, is not likely to fall in value. The first condition is there fore the prospect of general stability as regards both external and internal politics. In the next place the investor will need to be persuaded that general financial conditions are such that the new security which he is offered is likely to represent as much as he can expect to receive if he waits until his existing security is paid off and he has to seek a new investment. The normal type of con version would be somewhat as follows : A security is due for re payment or can be called by the borrower for repayment, say five years hence. The borrower wishes to replace that security now by a conversion issue carrying a lower rate of interest and repay able, say 3o years hence. His chance of persuading the holder to accept such a proposal will therefore depend on the holder's estimation of the relative advantages of making certain of a lower rate of interest for the longer period of 3o years, and of retaining for another five years his original (higher) rate of in terest subject to the risk that when paid off in five years time he will not be able to reinvest his money so profitably as if he had accepted the conversion offer. The second condition of success ful conversion is therefore a general belief that financial tend encies are such that future interest rates are likely to decline. The outward sign of such a belief is usually that the security to be converted is quoted in the market at or over its redemption value, for that means that the market thinks that the interest payable on that security is above the normal current rate. Thus for the 14 months previous to the Goschen conversion in 1888 Consolidated 3% Stock, had averaged £ i o 1 9s. 9d. in spite of the fact that the Government could call the stock for repayment at £ i oo. Finally much depends on the amount of the issue to be con verted. A very large issue is physically difficult to handle ; the number of holders who from ignorance or inertia will not respond to a conversion offer, even if advantageous to them, may in the aggregate be great ; and for both reasons the amount of the issue not converted may remain considerable. It may almost be said that in normal circumstances a third condition of successful con version is that not too much is attempted at any one time. In many cases there is a special feature which emphasizes the im portance of this condition. It is frequently necessary in order to bring holders into a conversion scheme to announce that such holders as do not convert will be paid off by the borrowing Gov ernment. The unwillingness of the holder to be paid off is a motive to induce him to convert. But a Government can only make such an announcement if it can feel sure that it can readily raise the amount of cash it will require to pay off those who do not convert. This will depend partly on the size of the issue and therefore of the probable unconverted remanet to be paid off ; and partly on the position of the Government's short-term debt. The Government will probably have to have recourse to short-term borrowing to meet the remanet, and the cost and possibility of such borrowing will depend entirely on the amount of short Government paper already in existence. At the time of the Goschen conversion the unfunded debt (treasury bills, exchequer bills and exchequer bonds) was only £17,385,100; and the Government had conse quently no difficulty in raising at reasonable rates the it temporarily required to redeem non-converted stock.

British Conversions.

The more important conversions of British Government debt have been as follows:— (a) Before the World War: Pelham offered holders of 4% stocks then standing above par a new stock bearing 4% interest till 1750, interest till 1757 and thereafter 3% interest. stock was converted at an annual saving of £272,067 for five years and then of £350,101; and the balance was paid off at par.

1822. Vansittart offered holders of Navy 5% and Irish 5%, then standing at 1o8$ to an amount of £152,422,143, a 4% stock at 1o5; £149,627,867 was converted at an annual interest saving of £1,197,025; and the balance of £2,794,276 paid off in cash. This conversion owing to the issue at 105 added £7,481,350 to the nominal total of the National Debt.

1824. Robinson offered' holders of L76,248,180 4 % annuities then standing at 1014 and new 31% stock at par. £68,000,00o was converted at an interest saving of £381,242 per annum.

1830. Goulburn offered holders of the £153,561,091 4% stock (remaining from Vansittart's operation in 1822) now standing at 1022, either 31% stock at par or 5% stock at 70. £150,790,179 was converted, all but £670,567 into 31% stock, with an annual interest saving of 1844. Goulburn offered holders of the ±248,860,663 32% stock resulting from the 1824 and 1830 conversions now standing at 1611 conversion at par into a stock carrying 31% for ten years and then 3%. £248,757,311 was converted at an annual saving of £621,893 per annum for the first ten years, and L1,243,786 per annum thereafter.

1884. Childers endeavoured to convert £612,761,061 3% stock standing at 1014 into either 2',1% stock at 102 or stock at 108. But only £22,362,595 was converted, at a saving in interest of £62,303 per annum, and an increase of £1,515,604 on the nominal total of the debt.

1888. Goschen offered the holders of £557,992,508 new 3% (Goulburn) Reduced Three per cents (Pelham) and 3% Consols, then standing at 1034, a new stock at par ("Consols") bearing 24% interest, to be reduced after 25 years to 21%. was converted (over 92%) at an annual saving of £1,411,943 for 25 years and of £2,823,886 thereafter. (It is interesting to observe that in every case the stock converted was standing at a high price; that the largest operation attempted, that of Childers in 1884, was a failure; and that chancellors of the Exchequer were not deterred by increase in nominal debt from effecting interest savings. It will also be observed that stocks originally 5% or 4% were brought down to 31 % or 22% by a series of operations. In the conversions of Vansittart, 1822, Goulburn, 183o and and Goschen, 1888 [except as regards Reduced Threes and Con sols] , the assent of holders to conversion was assumed unless they signified dissent within a prescribed period.) (b) Since the World War: Between March 31, 1914, and March 31, 192o, British Dead weight Debt rose from f 649,770,00o to f 7,831,744,000, and of the later enormous figure only some f 315,000,00o was permanent ly funded. The scope for debt conversion, provided that satis factory financial and political conditions could be secured, was thus large. In addition to cash amounting in the six years 1920 26 to f 708,308,00o applied out of revenue to debt redemption, and to very large reborrowings to meet maturities as they fell due, the British Treasury launched a number of pure conversion operations. These operations, still in 1928 in progress, should be regarded as a single whole rather than a series of separate trans actions each by itself comparable, say, to the Goschen conver sion. The difficulties arising from (a) the slow recovery to sound financial conditions, (b) the large amounts to be handled, and (c) the large outstanding floating debt are very clearly reflected in the relatively slow progress. The Treasury have had to con duct their operations under far from ideal conditions.

The main conversion operations have been as follows: April 192I. Holders of 5% National War bonds repayable at a premium on various dates from Oct. 1922 to Sept. 1925, were offered 32% Conversion Loan at £ 16o to £ 163 for each f 10o bond. f 164,000,000 5% bonds were converted into f 266,000,000 32% loan at an increased interest charge of L I , I 1 o,000 per annum against which must be set (a) the advantage of postponing the maturity for many years and avoiding an increase in short-term debt, (b) a saving of f3,381,00o in premiums.

February 1922. Holders of 5% Exchequer bonds were offered 32% Conversion Loan at £136. £14,500,00o were converted into f 19, 500,00o Conversion Loan, with an interest saving of £3 5,000 per annum.

April 1922. f 70,000,000

5% War bonds due in October 1922 and April 1923 converted into £94,000,000 32% Conversion Loan at £ 134, with an interest saving of f 218,000 per annum.

1923. f 11,000,00o 5% National War bonds converted at par (with cash payment of in V. %) into 42% Treasury bonds 1932. Interest saving, f 5 7,00o per annum.

1924. Holders of 5*% Exchequer bonds offered the choice of (a) 42% Conversion Loan 1940/44 at par (with cash pay ment of f215s %) or (b) 42% Treasury bonds 1934 at par. 182,000,000 of bonds were converted at par, with an annual in terest saving of f 1,026,800.

April 1924. Holders of 5% War Loan

1929-47 (to a total of £200,000,000) were offered 42% Conversion Loan 1940/44 at 103. f 148,000,0o0 was converted into £1 S3,00o,00o Conversion Loan at an interest saving of £S41,000 per annum.

1925. Three issues of 32% Conversion Loan: Jan. for L59, 66o,000; April £30,000,000 ; Sept. f4o,000,000; thus reducing the floating debt from f845,825,00o in 1924 to f816,641,000.

Oct. 1926. Holders of 5% Treasury Bonds invited to convert and £82,700,000 converted; Dec. new issue of Consolidated Loan, conversions to which amounted to f 128,060,313.

Feb. 1927. Holders of L135,247,000 5 % Treasury bonds 1135,258,00o 5% National War bonds were offered conversion into 42% Treasury bonds 1934 at par or 4% Consols at varying prices. f Treasury bonds and f War bonds were converted at an interest saving of 1466,o0o per annum. At the same time £35,420,000 tax free 4% War bonds were con verted into f41,796,000 4% Consols at an increased gross interest of f 165,000 per annum but subject to tax.

Dec. 1928. Holders of f 153,987,000 5% War bonds payable at io5 were offered 5% Treasury bonds 1933-35 at £1o5 1os. f I Io, 857,00o were converted into f I 16,984,00o Treasury bonds at an increase in interest of f3o5,o00.

Down to 1928 the net result of conversions on the annual in terest charge was not great. Their importance lay in providing by postponement for the heavy maturities of debt and in clear ing the way for future conversions. In 1932, as a measure to pro mote national recovery after the narrowly averted financial crisis of 1931, the large 5% War Loan was converted to 31%.

United States Conversions.-After the Civil War the Fed eral debt amounted to about $3,000,000,000 of which $5oo,000,000 was short-term debt. Secretary Hugh McCulloch commenced in 1865 by turning this short debt into 3o-year 6% Notes. By 1868 he had repaid out of surplus $519,000,000; and he then, while maintaining a high annual debt redemption, converted these 3o year Notes into 2o-year Notes (with a right to pay them off in five years). His successor, Secretary Boutwell, having further reduced the debt outstanding, was able in 187o to convert the 6% Notes into $200,000,000 5%, $300,000,000 42% and $1,000, o00,000 4% Notes.

After the World War the United States had the advantage of a debt two-thirds the size of that of Great Britain, very much larger resources on which to draw, and a revenue for many years consistently in excess of its normal appropriations, so that by December 31, 193o it had reduced its total indebtedness from $26,596,701,648.01 (Aug. 31, 1919) to $16,026,087,087.07. By a series of conversions in 1924, 1927, and 1928 it also cut its interest charges nearly $21,000,000. per annum.

But much more extensive refunding operations were carried out during the years 1933-35 when a favorable money market enabled the Government to bring its average interest rates down dras tically. Most conspicuous in this program was the redemption of all outstanding Liberty bonds, successive calls were announced for April 15, 1934, October 15, 1934, April June 15, and October 15, 1935; and before each date new bonds or notes at substantially lower rates were offered in exchange for the called issue. These offers -were all well subscribed with the result, according to a public announcement by Secretary of the Treasury Morgenthau, that the nation stood to save approxi mately $1oo,000,000. yearly in interest.

BIBLIOGRAPHY.-For

British conversions, particularly Goschen's Bibliography.-For British conversions, particularly Goschen's conversion of 1888, E. W. Hamilton, Conversion and Redemption (188g) ; and Report of Committee on National Debt and Taxation (1926) ; for United States Conversions, Annual Reports of the Secre tary of the Treasury for 1924, 1927, 1928. (O. E. N.)