Do Bonds Get Refunded and What Happens When They Are?

A bond represents a financial instrument, a loan an investor provides to a borrower. Governments, municipalities, and corporations issue bonds to raise capital for various projects or operations. In exchange for this loan, the issuer promises to pay the bondholder regular interest payments over a specified period and return the original principal amount, known as the par value, on a predetermined maturity date. Bond refunding is a practice where issuers manage their outstanding debt.

What Bond Refunding Means

Bond refunding is a process where an issuer refinances existing bonds by issuing new ones, similar to an individual refinancing a mortgage. This allows the issuer to retire older debt using proceeds from new securities. Not all bonds can be refinanced in this manner; only those with a “callable” feature are subject to early redemption by the issuer. A callable bond grants the issuer the right to buy back bonds from investors before their scheduled maturity date at a defined call price.

There are two primary types of bond refunding: current refunding and advance refunding. A current refunding occurs when the proceeds from the new bonds are used to pay off the existing bonds within 90 days of the new bonds’ issuance. Conversely, an advance refunding takes place when the outstanding bonds are redeemed more than 90 days after the new refunding bonds are issued. In an advance refunding, the proceeds from the new bond sale are typically placed into an escrow account and invested, often in U.S. Treasury securities, to ensure funds are available to pay off the old bonds at a future call date.

Why Bonds Are Refunded

Issuers refund bonds to achieve financial advantages. The most common reason is to reduce borrowing costs by issuing new bonds at a lower interest rate than existing ones. If market interest rates have declined since the original bonds were issued, an issuer can save on interest payments over the life of the new debt. For example, replacing a 5% coupon bond with a 3% coupon bond can lead to considerable annual savings.

Issuers may also refund bonds to remove or revise restrictive covenants attached to older agreements. These covenants might limit a company’s financial flexibility, such as restricting dividend payments or additional borrowing. Refunding can also simplify a complex debt structure or extend the maturity dates of existing debt, which can improve cash flow management by spreading out debt payments over a longer period. An improved credit rating for the issuer can also present an opportunity to refund bonds at more favorable terms, as a higher rating generally translates to lower borrowing costs. These decisions optimize the issuer’s financial position.

What Happens to Bondholders

When a callable bond is selected for refunding, the direct consequences for the bondholder are specific. Upon the bond being called, the investor typically receives the bond’s face value, also known as its par value, along with any accrued interest up to the specified call date. Sometimes, the issuer might also pay a “call premium,” which is an additional amount above the par value, intended to compensate the investor for the early redemption. This premium can vary, but it is often a small percentage of the par value, such as 1% to 5%, and may decline over the bond’s life.

After the bond is called, it is no longer outstanding, meaning the bondholder will no longer receive future interest payments from that specific bond. This can present a challenge for investors, particularly in a declining interest rate environment, a situation known as “reinvestment risk”. Reinvestment risk is the possibility that the bondholder will be unable to find new investments with comparable returns to the called bond, potentially forcing them to reinvest their funds at a lower interest rate. This scenario can lead to a reduction in the investor’s expected income stream.

Identifying Callable Bonds

For bond investors, understanding whether a bond is callable is important for managing their portfolio. Information regarding a bond’s callable features is typically detailed in several official documents. The bond’s prospectus or offering statement, which is a legal document provided by the issuer, will contain the specific terms and conditions of the bond, including any call provisions. These documents outline key terms such as the “call date,” which is the first date on which the issuer may redeem the bond, and the “call price,” the price at which the bond can be redeemed.

Investors should also look for details on any “call premium,” the additional payment above par that might be received upon redemption. A “call protection period” may also be specified, which is a period during which the bond cannot be called by the issuer. This information can also be found in confirmation statements received at the time of purchase or by checking with a financial advisor or brokerage firm. Not all bonds are callable; many are issued without this provision.