3
$\begingroup$

Background: In the 1710s, the British government borrowed heavily to finance wars. To reduce the interest on this debt, the government converted this debt into stock from a private company. The private company would only be paid a fee by the government equal to half the interest the government was paying on its debt. The company uses these fees to pay dividend on the stock it issues, which it uses to buy outstanding government debt.

Question: Why would an investor sell 1000 British pounds of debt that might pay 4% interest in return for 1000 pounds of stock in the company that paid only 2% dividends?

$\endgroup$
3
$\begingroup$

In the paper cited at the end of this answer, the incentives for all three parties involved are discussed. Not only did the creditors suffer from a lower return after the conversion, they also faced longer maturities and, given the strong heterogeneity in lending terms across bonds, also a destruction of bond specific information.

Nevertheless, conversions in line with your description were beneficial for the owners of the converted bonds since the conversion increased liquidity (the liquidity of the shares highly contrasted the illiquidity of government bonds) and reduced the probability of government default. In addition, the shares represented claims on rents of the company. Though, for the specific case of the South Sea Company, there have never been any rents involved.

Stephen Quinn, 2008. "Securitization of Sovereign Debt: Corporations as a Sovereign Debt Restructuring Mechanism in Britain, 1694-1750," Working Papers 200701, Texas Christian University, Department of Economics. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=991941

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.