What is a Refundable Bond? Definition, Explanation, and Calculation

Overview

Bonds continue to be a top investment choice for a couple of investors. People have multiple different investment options when it comes to bond investment.

These different types of bonds vary based on their returns and the manner in which the principal of the bond is generally treated.

Refundable bonds also referred to as refunded bonds, are considered one of the most commonly used bond types.

They are fairly technical, and hence, not very common in the private sector. The main underlying characteristic of refunded bonds is that they have their principal cash amount set aside by the original issuer of the debt.

As far as refundable or refunded bonds are concerned, it can be seen that both governments and private entities issue them.

It can be seen that refundable bonds are somewhat similar to callable bonds, but there are a few technical differences between both of them.

Definition

Refunded Bonds are mostly considered a subset of municipal and corporate bond classes. These are the bonds that have their principal amount set aside by the party originally issuing these bonds.

This is mainly done using a sinking fund. In the sinking fund account, the firm mainly uses the money to pay off debt from a given bond, or any other debt-related issue.

Furthermore, the sinking fund means giving the bond investors an added element of security that makes the overall transaction more secure from the bondholder’s perspective.

Refundable Bonds are often confused with pre-refunding bonds. However, that does not hold to be true.

Pre-refunding bonds are debt security that is issued to fund a callable bond.

With the pre-refunding option, the issuer exercises its right to buy back the bonds before the maturity date.

On the contrary, refundable bonds do not give the bondholder the right. The bond issuer withholds this discretion in most cases.

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Refunded Bonds and Pre-Refunding Bonds

Refundable Bonds are considered to be very low-risk investments. This is primarily because the principal amount is considered safe and secure since that is set aside at an earlier date.

The funds that are to be required to pay off refunded bonds are mostly held in escrow till the maturity date.

Therefore, the overall level of risk on the part of the investor is considerably low in this regard. Because of their lower risk profile, refundable bonds are similar to Treasury Bills, which offer a rate within the same threshold, and are considered to be of a similar risk profile.

As mentioned earlier, the main characteristic of refundable bonds is that their principal amount is set aside in escrow.

In this regard, it is important to understand that the main premise involved in refundable bonds is the concept of refunding.

Refunding in this regard means refinancing, or debt obligation. It is mostly issued by municipalities, which issue these new bonds to raise the finance required for retiring the existing bonds.

Subsequently, the bonds issued to refund older bonds are referred to as refunding or pre-refunding bonds.

On the other hand, the outstanding bonds, that are paid off from using the proceeds of the refunding bonds are referred to as refunded bonds.

Bond Refunding in Organizations

Bond Refunding is the concept of paying off higher costs bonds with the debt that has a lower net cost to the issuer of the bonds. This action is mostly undertaken to reduce the refinancing cost of the business. Bond Refunding is considered to be common under the following circumstances:

  • In the situation where the bond issuer has received a credit rating increase, which implies that they can take on debt at a lower cost compared to the bonds that were previously issued when they had a lower credit rating.
  • There is a considerably longer time frame over which the bond issuer must pay interests against the bond amount. Consequently, it is often viable to refund these bonds to offset the related transaction fee associated with refunding.
  • A fall in interest rates makes sense to refund the bonds and issue newer ones at a lower rate.
  • The new bonds can be issued at better terms and conditions as compared to the bonds that were previously issued.
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Therefore, it can be seen that refundable bonds are mostly issued by organizations when they think that they can refinance the amount at a considerably lower finance cost.

However, it must also be noted that existing bond agreements can mostly restrict bond refunding, so this option might not always be available to companies.

However, in the case where refunded bonds are possible to be issued, it can be seen that they might be used since they are considerably more attractive to investors.

This is because they can lock a certain rate of return on their investment for a relatively long time.

For Bond Refunding to hold, it can be seen that the following must behold:

  • Market Interest Rates are lower than the coupon rate on the bond.
  • The price of the bond is less than par.
  • The sinking fund has accumulated sufficient money to retire the bond issue.

How Do Companies decide on Refunding Decisions?

There are three steps that organizations go through when they decide whether they need to go for a refund or not.

These steps include the following:

Step 1 Calculation of Present Value of Interest Savings

Interest Savings are calculated using the following formula:

Interest Savings = Annual Interest Rate of Old Bonds – Annual Interest Rate of New Bonds

Step 2 – Calculation of Net Investment

This includes all the costs associated with the new issue of the bonds, in addition to the after-tax call premium and the overlapping interest.

Step 3 – Calculation of Net Present Value of Refunding

NPV of Refunding is calculated using the following formula:

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Net Present Value of Refunding = Interest Savings – Net Investment

If NPV is positive, then organizations go ahead with refunding the bond. Otherwise, they choose to stick with the old issue.   

Bond Valuation – How to Calculate Price of Refunded Bonds

To understand how bonds are valued, it is important to consider the characteristics of a regular callable bond. They include the following:

  • Coupon Rate: The interest rate that is rendered on the said bonds.
  • Maturity Date: The date at when the principal is likely to be repaid to the bondholder
  • Current Price: The face value of the bond, or the issuing price of the bond

To calculate the price of the bond, cash flows from the coupon payment and cash flows from the face value of the bond are subsequently added.

In this regard, to calculate the present value of expected cash flows, the following formula is used:

V (Future Coupon Payments) = Coupon Rates / (1+r) T

Where r = interest rate, and T = number of periods

On the other hand, the present value of the face value of the bond is calculated as the following:

V (Face Value) = Face Value of the Bond / (1+R) t

Where R = discount rate (or Yield to Maturity), and t = date till maturity