Refinancing debt is a common way to take advantage of improved financial conditions in the market or the improved health of a corporation that allows a company to put itself in a stronger position, both operationally and financially. There are a few situations that arise that propel a company to refinance, which are discussed in this article.
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 before 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.
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 or a lower interest rate.
- 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.
- Companies often refinance their debt when they are in financial duress and cannot meet their debt obligations.
- Companies that are not in financial duress refinance their debt to take advantage of lower interest rates or an improved credit rating.
- Refinancing debt results in lower monthly payments, which in turn frees up cash that can be utilized for other needs.
- A company can refinance its debt by replacing its current debt with a lower interest rate debt.
- Issuing new equity to pay down the debt load is another method of refinancing.
When a company issues debt, usually in the form of long-term bonds, it agrees 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 will enable it to pay a smaller interest charge.
Conversely, if a company takes out a loan, it pays an interest rate on that borrowed money. When interest rates drop, a firm can take advantage of the lower interest rates by refinancing its debt, resulting in lower monthly payments on its loan.
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 to 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 require a lower return than before, a company will probably want to refinance its older debt at the new rate.
Debt refinancing is a smart choice, but it may not always be possible in certain situations. Some debt comes with call provisions that place a penalty for refinancing debt. Also, refinancing comes with closing costs and transaction fees, which may be extremely high.
A company may also refinance if it 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).
The Bottom Line
A company can refinance its debt by taking advantage of lower interest rates and an improved credit rating. After a 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.