Bond refunding is the concept of paying off higher-cost bonds with debt that has a lower net cost to the issuer of the bonds. This action is usually taken to reduce the financing costs of a business.
Bond refunding is particularly common under the following circumstances:
- The bond issuer has experienced a credit rating increase, and so can expect to obtain debt at a lower cost than had been the case when the existing bonds were issued at a lower credit rating.
- There is a substantial period of time over which the bond issuer will have to continue paying interest on the existing bonds, so refunding them will easily offset any related transaction fees associated with the refunding.
- Interest rates are now at a lower level than they were when the bonds were issued.
- The bond issuer can obtain replacement debt that carries fewer restrictions than are imposed in the bond agreements. For example, a bond agreement may state that no dividends can be issued for as long as the bonds are outstanding. Shareholders may pressure management to recall these bonds in order to issue them a dividend.
Most of the preceding points should make it clear that bond refunding is triggered by the opportunity to refinance at lower rates. Only in the last case do other factors have an impact on the refunding decision.
Bond refunding may be restricted by the existing bond agreement, which may prohibit or at least restrict it to certain dates, or only after a certain amount of time has passed since the bonds were originally issued. This is done to make the bond offering more attractive to investors, who want to lock in a certain rate of return on their investment for the longest period of time possible.