What is Bond Refunding?
Bond refunding can be defined as a corporate financial planning activity undertaken with the objective of lowering financing cost by retiring or repaying old outstanding bonds issued previously with high-interest rates with the help of proceeds collected from new debts issued usually having lower interest rates.
Bond refunding is a corporate action whereby funds procured from investors are repaid to them with the help of newly issued bonds, i.e., the company repays old bondholders with the money received from new bondholders. It is regulated by the agreement of bond, which may restrict the holder to repay the bond until a certain period or date. It is a practice to attract initial investors who wish to lock their funds for a certain period of time at a desired rate of return.
A bond may be sold before maturity in order to lower the cost of finance. It may also be refunded due to the increase in the credit rating of the bond issuer, which will help the bond issuer to procure funds at lower interest rates. Sometimes refunding bonds offset refunding fees and other transaction charges instead of continuing to repay interest. BondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually. may also be refunded to lower the restrictions applicable to them.
Wallmart Inc. issues $200 million bonds on 15/06/2018 with an interest cost of 10%, but with market conditions and increased credit rating Wallmart is getting lower rate debts, so it decides to call back previous bonds costing 10% and replace them with new $200 million bonds with 5% interest cost.
Accordingly, Wallmart Inc., on 01/12/2019, issues new bonds and, at the same time, calls back old bonds with a 10% cost. The funds coming from new bonds was utilized towards payment of old bonds and thus causing it a saving of $10 million(5% of $200M).
Bond Refunding Process
During a given time frame, interest rates vary depending upon certain determining factors like inflation, opportunity cost, etc. If the interest rate on bond decreases from the interest rate at which the bonds are purchased, the owner of the bond may pay off the bond before its maturity and refinance it at the lower interest rate prevailing in the market. Funds obtained from the reissue of the bonds at a lower rate are used to settle dues from the old bondholders.
This process is very frequently practiced in the market where the interest rate has fallen as the existing debt is likely to be paid with the cheaper debts from the current market. Refunding is not so easy. It occurs only with callable bonds. Callable bondsCallable BondsA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond's maturity. This right is exercised when the market interest rate falls. are the bonds that have the clause to get redeemed before its maturity period. Under these bonds, holders have to face the risk of bonds being calledRisk Of Bonds Being CalledCall risk is the uncertainty that arises when the investors purchase bonds but perceive that the issuer will redeem this debt instrument before its maturity date. Thus, resulting in the possibility that the investors would have to reinvest the disbursed amount at a much lower rate or in an unfavourable investing market scenario. up by the owner before the maturity period due to a decline in interest rate. This was the common practice by the bond issuers.
Therefore, in order to protect the bondholders from premature redemption, a clause known as the call protection clause was inserted in the bond agreement. This call protection clause indicates the lock-in period of the bond, which fixed time limits before which the bond cannot be called up. If the interest rate falls too low during the lock-in period, which calls for redemption of bonds, at such time, the owners are allowed to issue new bonds in the interim period where the sell proceeds of interim bonds will be used to buy treasury securities, which need to be deposited in the escrow account.
Interest earned on escrow accountEscrow AccountThe escrow account is a temporary account held by a third party on behalf of two parties in a transaction. It reduces the risk of failing to oblige the transaction by either of the parties. It operates until a transaction is completed and all the conditions are met. will help to pay-out interest on already issued high-interest rates bonds. When the lock-in period expires, these treasuries are sold, and the deposited funds in the escrow account are utilized to pay bonds liabilities. Money is repaid to all bond-holders as per their entitlement.
Bond Refunding vs. Bond Refinancing
- Bond refunding is the process of reissuing new bonds in place of existing bonds, while bond refinancing is a totally different concept. Unlike bond refunding, it does not refund the money the investor.
- Bond refinancing is the restructuring of bonds instead of the repayment of money to the investors. It is very helpful for a business to reduce funding cost as under it, the organization can take advantage of the new interest scheme and, at the same time keeping old bods intact. Refinancing is a risky business for the bond owner as the returns are not as attractive as complete repayment of funds in case of bond refunding.
- It helps issuer to obtain, replace, and utilize lower-cost funds in place of pre-existing high-interest bonds already issued.
- It helps the company in capital restructuring and maintaining adequate debt-equity ratioDebt-equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. ;
- Regular repayment of a bond on time will lead to an increase in the credit rating of the company, which in turn will attract more investors and thereby funds;
- This may be helpful to avail of certain income tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place. as provided by income tax governing agencies.
- As this activity is undertaken to reduce finance cost, bondholders may feel discomfort in exercising this option as the interest rate payable on already issued bonds was higher than on bonds currently available in the market.
- Undertaking bond refunding involves transaction costs also. There are various legal and commercial compliances which need to be fulfilled by companies that need to be completed before undertaking bond refunding. Also, there are certain other transaction costs like brokerage, taxes, commission, etc.
- Frequent bond refunding by any corporate may lead to an adverse impact on the image of the company as the investor will form an opinion about a company that funds will not be kept invested for their desired time period and may be refunded earlier, which may cause difficulty in fund procurement.
Bond Refunding can be defined as a capital restructuring activity undertaken by any corporate to lower down its cost of borrowing. Usually, already issued bonds are repaid or retired at maturity or even before maturity (if allowed as per bond agreement) with the proceeds of newly issued bonds with a lower interest rate. Market interest rates keep changing, and to avail the benefit of lower interest cost funds, corporates usually undertake this task.
This has been a guide to What is Bond refunding & its Definition. Here we discuss the process of Bond refunding and examples along with advantages and disadvantages. You can learn more about from the following articles –