What is Debt Refinancing?
Debt Refinancing is the replacement of an existing debt obligation with a new issuance, typically to take advantage of more favorable lending terms.
How Does Debt Refinancing Work?
Debt refinancing among corporations is most common in low interest rate environments.
When interest rates are falling, the corporation might view the prevailing economic conditions as an opportunity to refinance existing debt, such as a loan, with more favorable terms.
In most cases, the new debt issuance would be priced at a lower interest rate, along with a longer maturity, i.e. the date on which the principal must be repaid in full is also extended.
Apart from the favorable lending environment, an improved credit rating is another factor that can influence a company’s decision to refinance its existing debt.
For instance, a corporation might seek a debt refinancing after reporting positive financial performance and risk profile regarding its credit risk, which could warrant a lower cost of debt.
In comparison to the financial state the borrower was in on the date of original issuance, its current risk of default could be substantially lower due to such recent developments.
Thus, a potentially reduced interest rate is reflective of the company’s progress in terms of its credit rating and the financial ratios used by the lender to determine the rating.
What are the Pros and Cons of Debt Refinancing?
First and foremost, the decision to refinance an existing debt obligation is ultimately up to the lender (and is governed by the original lending agreement).
Otherwise, all corporate borrowers would refinance their debt during low interest rate environments, which would clearly be unrealistic.
Certain corporate loans contain a call provision that prohibits prepayment for a set number of years.
The decision to repay the debt early can also trigger a prepayment fee (i.e. “call premium”), which is meant to compensate the lender for the interest payments that had not yet come due and will not be received once the debt is retired.
Therefore, companies must ensure that the monetary benefit of the refinancing outweighs the costs.
If the prepayment fees offset most (or all) of the marginal benefits, the refinancing might not make sense economically.
Another consideration is the tax implications—i.e. the savings from the “interest tax shield”—which could decline following the refinancing.
Furthermore, the refinancing is likely to incur new costs related to paying for advisory services.
In effect, the decision to refinance can easily become a complicated matter, rather than simply proceeding with the refinancing because of the lower interest rate environment.
But one of the more influential considerations is that debt financing is often a recurring source of capital for corporations, i.e. reliance on debt is part of the company’s long-term business model.
With that in mind, securing a very low interest rate on a refinancing could be counterproductive in the near-term, yet still make sense if the cost savings eventually pay off over the long run.
Debt Refinancing vs. Debt Restructuring: What is the Difference?
While the terms “debt refinancing” and “debt restructuring” are occasionally used interchangeably, there is a subtle distinction.
- Debt Refinancing → The refinancing of debt tends to be a discretionary, strategic decision made by a corporation, after weighing the pros and cons of such a transaction. The management team’s objective is to adjust the capital structure to get closer to its “optimal” state (i.e. to maximize the firm valuation).
- Debt Restructuring → In contrast, the restructuring of debt is performed under more dire circumstances, where the borrower can no longer handle the current debt burden. Unless the terms of the existing debt are renegotiated, the borrower is at risk of becoming distressed (and filing for bankruptcy). For example, the borrower and lender could agree to extend a maturity date out of necessity, so that the debt load becomes manageable and the borrower is more likely to remain afloat (and not default on its obligations).