When a company chooses to refinance its debt, it can do so by taking one or both of the following actions:
- Restructuring or replacing the debt, generally with a longer time to maturity and/or lower interest rate, or
- Issuing new equity to pay down the debt load. This option is generally exercised when the company can't access traditional credit markets and is forced to turn to equity financing.
The Whys of Corporate Debt Refinancing
Most times, companies refinance or restructure their debt when they are in financial difficulty and are unable to meet their obligations, generally prior to filing for Chapter 11 bankruptcy protection. However, that's not always the case. Favorable market conditions or the strengthening of a company's credit rating may also lead to the refinancing of corporate debt. The two primary factors for influencing a company not in financial distress to refinance are decreases in the interest rate or improvements in the company's credit quality. Taking this kind of action can free up cash for operations and further investment that would bolster growth.
The Role of Interest Rates
When a company issues debt, usually in the form of long-term bonds, it is agreeing to pay a periodic interest charge, known as a coupon, to the bondholders. The coupon rate reflects the current market interest rates and the company's credit rating.
When interest rates drop, the company will want to refinance its debt at the new rate. Because the debt was issued during a time of higher interest rates, the company is paying more in interest than what current market conditions would specify. In this case, the company may refinance by issuing new bonds at the lower coupon rate and then use the proceeds to buy back the older bonds. This allows the company to capitalize on the lower interest rate, which allows it to pay a smaller interest charge.
The Role of a Company's Credit Rating
A company's credit rating is reflected in the coupon rate on newly issued debt. A less-financially secure company, or one with a lower credit rating, will need to offer lenders more of an incentive – in the form of a higher interest rate – to compensate them for the additional risk of extending credit in that company. When a company's credit quality improves, investors won't require such a high interest rate to provide credit because that company's bonds will be a safer investment. If lenders are requiring a lower return than before, a company will probably want to refinance its older debt at the new rate.
A corporate refinancing may also be undertaken if a company expects to receive a cash inflow from a customer or other source. A significant inflow can improve a company's credit rating and bring down the cost of issuing debt (the better the creditworthiness, the lower coupon they will need to pay).
After the company refinances its debt, it generally reaps several benefits, including improved operational flexibility, more time and cash resources to execute a specific business strategy and, in most cases, a more attractive bottom line due to decreased interest expense.