What is Debt Refinancing?
Refinancing refers to the process of revising the terms of an existing credit agreement to facilitate favorable changes to the interest rate, payment schedule, and/or other terms of the agreement. The changes are generally reflective of current market conditions and the company’s credit rating. Debt refinancing helps a company reorganize its financial obligations by replacing existing credit agreements and typically provides greater operational flexibility in terms of time to maturity and cash resources.
Key Learning Points
- Debt refinancing is a process through which a company reorganizes its financial obligations by modifying the terms of existing debts.
- Companies aim to refinance their debt to reduce interest payments, modify payment schedules, find more favorable loan terms, reduce risk, and/or access more cash.
- Debt refinancing tends to be more common during periods of falling interest rates.
- Debt refinancing has significant associated costs that should be considered when evaluating the process.
Companies generally seek to refinance debt obligations to obtain more favorable borrowing terms, often in response to shifting economic and market conditions.
The prevailing interest rate is one of the biggest drivers in refinancing corporate debt. When a company issues debt, the coupon schedule reflects the prevailing market interest rates and the company’s credit rating. Because interest rates are cyclical, a stronger economy may be accompanied by lower interest rates. During these lower rate periods, many companies may choose to refinance and reduce their debt obligations.
When a company’s credit improves substantially after the debt has been issued, it is possible to refinance outstanding debt at a lower rate that is reflective of the improved circumstances. Companies refinance when the benefits outweigh the costs associated with refinancing.
If a company receives a substantial cash inflow, the event may improve a company’s financial ratios (solvency, liquidity, and debt) and thereby its credit rating. Refinancing can lead to reducing outstanding debt and lowering interest costs.
Strong Equity Performance
If shares are trading at elevated levels, a company’s leverage is lowered. The company can double down on the higher stock price to issue equity and reduce debt, further lowering the debt-to-equity ratio. The company is then well-positioned for any future debt financing.
Businesses periodically evaluate their balance sheets to identify debt that could be refinanced at a lower rate or based on an improved credit profile. Companies refinance for a variety of reasons, some of which include reducing interest rates on loans, consolidating debt, altering the loan structure, or freeing up cash. Moreover, the type of debt a company issues depends on its specific needs. There are several types of refinancing options, some of which include:
- Rate-and-term refinancing: This occurs when a company issues new debt, which is used to replace the original loan. The new debt carries lower interest payments and may offer a more favorable timeline to make the interest payments. This is the most common type of refinancing.
- Cash-out refinancing: This is common for a debt taken on collateralized assets. Such refinancing may be undertaken when the underlying asset has increased in value or the equity portion of the asset has increased due to periodic payments. Cash-out refinancing allows a (partial) withdrawal of equity in the asset in exchange for higher debt. Although the level of debt increases, the company gains access to cash.
- Cash-in refinancing: Like cash-out refinancing, cash-in refinancing also requires collateralized assets. If a company has excess cash on hand, it can use this cash to pay down some portion of outstanding debt and lower the loan-to-value (LTV) ratio, resulting in smaller payments and/or a shortened payment schedule.
- Debt consolidation: A company may have several outstanding debts taken on at different times at rates higher than the prevailing rates. In such cases, consolidating some or all of the outstanding debt may be an effective way to refinance. The company obtains a single loan at a rate lower than their current average interest rate across several credit products. This single loan can then be used to pay off the existing debt resulting in a lower overall interest payment schedule.
Another term that tends to be used interchangeably with refinancing is restructuring. Fundamentally, both involve reorganizing a company’s debt to improve its operational flexibility and financial position. The difference is that debt restructuring is done when the borrower is experiencing financial distress and is unable to meet their payment obligation. It is often done even when market conditions or the company’s credit ratings have not improved, or have even deteriorated. Debt refinancing is much broader, occurring when a borrower leverages improved market conditions or credit position to obtain better terms. The result of corporate refinancing is generally an improvement in the company’s financial outlook. However, there may be associated penalties, closing costs, and transaction fees with refinancing that should be considered and may make refinancing prohibitive.
Let’s look at an example to see when debt refinancing makes sense and when it would not.
It is important to note that there are several factors, besides economic, that ultimately impact the decision to refinance. The determination is generally on a case-to-case basis.
Debt refinancing allows a company to take advantage of an improved credit rating and/or conducive market conditions such as lower interest rates. When the benefits outweigh the cost of refinancing, this can take the form of improved operational flexibility, more cash, and a preferable obligation timeline to execute business strategies.
Disclosure: This article was prepared by Saumil Bhansali, a Director with Oppenheimer & Co. Inc. His opinions do not necessarily reflect those of the firm. This article is not and is under no circumstances to be construed as an offer to sell or buy any securities. The material herein has been obtained from various sources believed to be reliable and is subject to change without notice.
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