Updated July 14, 2023
What is Bond Refunding?
The term “bond refunding” refers to the corporate financial strategy wherein the bond issuer plans to retire or repay the old outstanding bonds with the proceeds collected by issuing new debts.
The strategy aims to lower financing costs by replacing the old bonds issued at high-interest rates with new bonds with lower interest rates. This strategy is usually seen in a reducing interest rate environment.
Explanation
In corporate finance, bond refunding refers to the process wherein the bond issuer retires some of its outstanding high-interest-rate bonds (callable) and replaces them with low-interest-rate new bonds. Issuers with significant debt loads are incentivized to issue new bonds at favorable terms as it reduces their financing costs with cheaper debt.
How Does Bond Refunding Work?
In the fixed-income market, there is always a chance that the interest rates will change. In the case of a low-interest-rate environment, if the market interest rate falls below the coupon rate offered on the outstanding bonds, then the issuers tend to pay off the old bonds and refinance them at a lower interest rate prevailing in the market. The company uses the proceeds from the newly issued bonds to pay off the principal and interest obligations of the old bonds.
Example of Bond Refunding
Let us take the example of SDF Inc., which has $50 million in capital raised as an 8% bond that will mature in the next 10 years. These are callable bonds; the call premium is 2% of the par value. The market interest rates have decreased significantly, and SDF Inc. can raise new 10-year bonds at a 4% coupon rate. First, determine the cost incurred in year 0 and the annual savings thereafter due to bond refunding, given that the flotation costs of the new bond issue are $100,000.
Solution:
The cost incurred in terms of call premium can be calculated as,
- Call Premium = $50,000,000 x 2%
- Call Premium = $1,000,000
The total Cost incurred for the new bonds can be calculated as,
Total Cost = Call premium + Flotation cost
- Total Cost = $1,000,000 + $100,000
- Total Cost = $1,100,000
Now, let us calculate the annual coupon payment as per the old issued bonds,
- Annual coupon payment Old bonds = $50,000,000 * 8%
- Annual coupon payment Old bonds = $4,000,000
Again, let us calculate the Annual Coupon Payment as per the newly issued bonds,
- Annual Coupon Payment New Bonds = $50,000,000 * 4%
- Annual Coupon Payment New Bonds = $2,000,000
Therefore, annual savings in coupon payment can be calculated as,
Annual Savings = Annual Coupon Payment Old Bonds– Annual Coupon Payment New Bonds
- Annual Savings =$4,000,000 – $2,000,000
- Annual Savings = $2,000,000
Therefore, the total cost of the new issue is $1,100,000, and the annual savings due to bond refunding is $2,000,000.
Bond Refunding Charges
The charges of bond refunding usually include the call price, which is the excess value of a callable bond vis-à-vis its par value without the call option. This is because the issuer needs to pay the call premium to have the option to acquire the issued bonds prematurely in case of a declining interest rate environment or any other similar situation. In addition, bond refunding charges also include brokerage, commission, taxes, and expenses toward legal and commercial compliances.
Bond Refunding Analysis
The decision of bond refunding involves two major questions – (1) is it economically feasible to call back the outstanding bonds at the current interest and replace them with the new issue; and (2) would the expected value of the firm improve further if the bond refunding is done on a later date.
The decision to refund the bond has to take into account the following costs to determine the cash outflow:
- The company pays a call premium for exercising the call option.
- The company incurs costs for selling newly issued bonds, known as floatation.
- The company adjusted tax savings due to the write-off of the flotation costs of the older issue.
- The company is responsible for paying net interest while both old and new issues are outstanding in the market.
On the other, the annual savings in terms of interest payment due to interest rate differential plus the net tax savings due to amortization of the flotation expenses on the newer issue constitute the cash inflow. The strategy adds value if the cash inflow is adequately higher than the cash outflow.
Advantages
Some of the major advantages of bond refunding are as follows:
- First, it helps the bond issuer replace the existing high-interest-rate and new low-cost bonds.
- It helps the issuers improve their capital structure and maintain a suitable debt-equity ratio.
- It results in lower debt repayment obligations, which improves the issuers’ financial position.
- Several tax benefits associated with bond refunding provide additional support to the operating performance of the issuers.
Disadvantages
Some of the major disadvantages of bond refunding are as follows:
- First, the holders of the existing bonds with higher coupon bonds aren’t very happy with the strategy as it results in the premature stoppage of cash inflow, or at best, they have to contend with lower coupon rate bonds.
- It can be a cumbersome process with various transactional cost components, including legal and commercial compliance expenses and other transaction costs like brokerage, commission, taxes, etc.
Conclusion
So, it can be seen that bond refunding is a kind of capital restructuring that corporates undertake to lower their cost of borrowing. Typically, the existing bonds are retired or repaid at maturity (or even prematurely in the case of callable bonds) with the help of the proceeds received from the issue of the new bonds. If implemented with proper market analysis, this strategy can be financially profitable for corporations.
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