What is refunding?
In the capital market and corporate finance, refunding stands for the process in which the bond issuer retires part of the outstanding bonds to obtain new bonds in exchange. Generally, the terms of the new bonds are more favourable, and the financing cost is also reduced. With the issuance of the new bonds, the sinking funds are created that are used to repay the original bonds, which is also known as refunded bonds.
In the commercial and retail space, refunding can also be understood as a process in which the transactions are reversed because of the poor quality of product and services offered to the customer. By refunding, enterprises aim at maintaining the customers’ loyalty for long term.
- Refunding stands for the process in which the bond issuer retires part of the outstanding bonds and in exchange new bonds are issued by the issuer.
- The terms of the new bonds are more favourable and the financing cost is also reduced.
- In the commercial and retail space, refunding can also be understood as a process in which the transactions are reversed because of the poor quality of product and services offered to the customer.
Frequently asked questions (FAQs)
What is the working of refunding?
The outstanding bonds are redeemed in the refunding process. The refunding includes the principal amount and the interest amount applicable on it, by utilising the proceeds from the new debt issued.
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Generally, the newly issued debt includes a lower rate of interest in comparison to the refunded bonds. As a result, the interest expense of the issuer reduces significantly. Issuers also undertake the refunding process in order to remove any restrictions that are tied up with the existing bonds.
There is a relationship between the interest rate and the issuance of new bonds. When bonds are issued, then there are high chances that the interest rate will change within the economy. When the interest rate falls below the coupon rate of the bonds, then the issuer might pay off the outstanding bonds as the issuer can refinance the debt at lower interest rates that are present in the market. The proceeds from the issue will be used for paying off the principal and interest amount of the existing bonds. Thus, the process of refunding is a common phenomenon when the rate of interest is lower in the economy, as the issuer gets an incentive to reduce their debt loads by issuing cheaper debt against the existing higher-cost bonds.
What is the process of refunding the bonds?
The rate of interest is dependent upon factors like opportunity cost, inflation, government policies and so on. If the bond’s interest rate reduces from the interest rate at which the bonds were issued, then the issuer pays off all the principal and interest amount on the bonds before the maturity of the financial asset. Then it refinances the bond at the lower rate of interest that is prevailing in the financial market. The amount received after the issuance of the new bonds is issued for paying off the debts associated with the existing bonds.
This is a common practice that is adopted by the issuers when the interest rate falls in the financial market where the amount due on the existing bond is paid off by issuing cheaper bonds. However, conducting the whole process is not an easy task as there are some conditions that need to be fulfilled.
Refunding can only be conducted on the callable bonds, that is, the bonds which have a clause that they can be redeemed before the maturity of the asset. In this bond category, the bondholder faces the risk of bonds being redeemed before maturity in case the interest rate falls in the current market.
To safeguard the interest of the bondholders from redemption before maturity, a clause is included in the bond agreement, termed as call protection clause. Under this clause, a specific time period is fixed known as the lock-in period, during which the issuer cannot redeem the bonds. In case the interest rate falls significantly during the lock-in period, then the issuer can issue new bonds for the short term and the proceeds will be used for purchasing treasury securities that are deposited in the escrow account.
The interest income generated on the treasury securities is utilised for paying the interest on the existing bonds (that have a high rate of interest). As the lock-in period expires, then the treasury securities are sold in the open market and the same fund is used for paying off the debts associated with the existing high-rate bonds. The funds are paid off as per the agreement and new bonds can be issued at a lower rate of interest.
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What is the difference between bond refinancing and bond refunding?
In bond refunding, new bonds are issued against the existing outstanding bonds. In bond refinancing, the principal and the interest amount are not refunded to the holders.
The bonds are restructured in the bond refinancing instead of paying off the amount to the bondholders. Refinancing reduces the funding cost of the organisation and the organisation takes advantage of the prevailing lower rate of interest. Moreover, the old bonds remain intact. Generally, the bondholders prefer refunding over refinancing as the returns are reduced and they do not receive the complete payment as in the case of bond refunding.
What are the advantages of bond refunding?
- The issuers can replace the existing high-cost bonds with low-cost bonds.
- The companies can maintain their debt-to-equity ratio with the refunding process.
- More investors can be attracted along with the increase in the credit rating when the repayment is done on a timely basis.
- The company can also avail tax advantages as offered by income tax agencies.
What are the disadvantages of bond refunding?
- The refunding process might create a situation of discomfort for the bondholders as they will be receiving a lower return on the bond investment in comparison to the amount they were receiving earlier.
- The cost of conducting the refunding is present such as the cost of commission, taxes, brokerage and so on. Moreover, there are some compliance requirements that the company needs to fulfil.
- If a company conducts a lot of refunding, then the company may attract a negative image in the market as investors might feel that their funds will be disinvested in a short span of time. Thus, the company might face problems in procuring funds in future.