Refunding

What Is Refunding?

In corporate finance and capital markets, refunding is the process where a fixed-income issuer retires some of their outstanding callable bonds and replaces them with new bonds, usually at more favorable terms to the issuer as to reduce financing costs. The new bonds are used to create a sinking fund to repay the original bond issues, known as refunded bonds.

Refunding may also refer to reversing transactions in the retail or commercial space, often to make a customer whole due to a faulty or poor quality product or service.

Understanding Refunding

Refunding redeems an outstanding bond issue at its maturity value, typically the full amount of the outstanding principal plus any applicable interest, by using the proceeds from the newly issued debt. This new debt is, almost always, issued at a lower rate of interest than the refunded issue and, often, results in a significant reduction in interest expense for the issuer. Another reason for refunding is to remove any undesired restrictions and covenants that are tied to the terms of the existing bonds being refinanced.

When bonds are issued, there is a chance that interest rates in the economy will change. If interest rates decrease below the coupon rate on the outstanding bonds, an issuer will pay off the bond and refinance its debt at the lower interest rate prevalent in the market. The proceeds from the new issue will be used to settle the interest and principal payment obligations of the existing bond. In effect, refunding is likely to be more common in a low interest-rate environment, as issuers with significant debt loads have an incentive to replace their maturing higher-cost bonds with cheaper debt.

For example, an issuer that refunds a $100 million bond issue with a 10% coupon at maturity and replaces it with a new $100 million issue (refunding bond issue) with a 6% coupon, will have savings of $4 million in interest expense per annum.

How Refunding Works

Refunding only occurs with bonds that are callable. Callable bonds are bonds that can be redeemed before they mature. Bondholders face call risk from holding these bonds—risk that the issuer will call the bonds if interest rates decline. To protect bondholders from having the bonds called too early, the bond indenture includes a call protection clause. The call protection is the period of time during which a bond cannot be called. During this lockout period, if interest rates drop low enough to warrant refinancing, the issuer will sell new bonds in the interim. The proceeds will be used to purchase Treasury securities, which will be deposited in an escrow account. After the call protection expires, the Treasuries are sold and the funds in the escrow are used to redeem the outstanding high-interest bonds.

The new debt issues used in the process of refunding are referred to as pre-refunding bonds. The outstanding bonds that are paid off using proceeds from the new issue are called refunded bonds. In order to retain the attraction of its debt issues to bond buyers, the issuer will generally ensure that the new issue has at least the same—if not a higher—degree of credit protection as the refunded bonds.

Reversing Transactions

In addition to its use in the bond market, the term "refunding" may also refer to its more colloquial use in reversing a retail or commercial transaction. Businesses and merchants may issue refunds to customers in exchange for the return of purchased goods and when services are unsatisfactory or unfulfilled. Some businesses have liberal return policies that allow customers to return purchased goods at any time for any reason and receive a full refund, with or without a receipt.

Typically, e-commerce businesses wait until the returned product is received before they will issue a refund. Companies create return policies that strike a balance between excellent customer service and not compromising the company's profitability. Service providers may allow partial or full refunds for unsatisfactory or unfulfilled services.