Asset Substitution Problem

  

Categories: Stocks, Bonds, Trading

Usually, a lot of people have financial interest in a company's success. The list includes both shareholders and bondholders, as well as groups like employees and even customers. Generally everyone wins when the company does well. But situations arise where the interests of two groups might diverge.
One of these possible points of conflict forms the basis of the asset substitution problem.
Shareholders, or people who have stock in the company (and therefore own it), get paid when the company shows growth. Pushing stock prices higher generally requires earnings and revenue to rise, and the sharper the rise the higher the payout is likely to be. So shareholders generally like the company to take riskier bets, pushing into higher growth areas.
Bondholders, or the people who own bonds issued by the company (also known as people who have lent the company money), get paid regular interest payments. Growth rates don't really impact them that much. They just want the company to remain solvent so they can keep getting their regular coupon payments. So bondholders generally prefer a safer strategy, encouraging management to take a more turtle-like, slow-but-steady approach to corporate strategy.
The asset substitution problem comes up when a company has low-risk assets on the books when it sells a bunch of bonds, but then switches these out for higher-risk assets once it has the money in hand. For this term, don't think of assets as "stuff they own." Think of it more generally as "where their resources are invested."
It would be like saying to your mom, "I know I said we were going to Branson for spring break when you loaned me that money, but we changed our minds. Now we're going to Vegas."

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