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."
Related or Semi-related Video
Finance: What are Bonds?393 Views
Finance a la shmoop what is a bond? well a bond is your word your promise your [Women shake hands]
handshake your John Hancock on a contracted piece of paper your mortgage
your credit card debt yeah their bonds to your "I swear I'm not a deadbeat"
declaration... that's your bond right well bonds come [Man lying on a sofa]
in many complex flavors and compositions simply put bonds are loans aka debt you
borrow money or you promise or you you bond that
you'll pay it back when you borrow money the amount you borrow is called the
principal you pay rent on that amount borrowed and that rent is called [rent appears at bank]
interest to the entity loaning you the money that interest is called yield
thank you very much for the yield like if the lender rents you a grand for a
year and you pay them a thousand 80 bucks at year-end paying back the
principal and then the rent on the money while the lender will have had a yield [Yield of lender appears]
of 8% on the grand that they loaned you so that's a bond you borrow money you
pay it back and if you don't the person who loaned you the dough well they [Person stamped with property of shmoop bank]
generally own your tuchus and yeah you know what Shakespeare said about bonds
yeah that's what he said so if you don't really know what you're doing don't do
it...
Up Next
What is Cumulative Voting? When public companies have ballots for shareholders to vote for board members, shareholders have a total number of share...
What is non-voting stock? Non voting stock is a class of stock that carries no voting rights on agenda items subject to shareholder vote. While som...