DEFINITION of Refunding
Refunding is the process of retiring or redeeming an outstanding bond issue at maturity by using the proceeds from a new debt issue. The new issue is almost always issued at a lower rate of interest than the refunded issue, ensuring significant reduction in interest expense for the issuer.
BREAKING DOWN Refunding
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.
Refunding only occurs with bonds that are callable. Callable bonds are bonds which 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 an 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 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.