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A refunding bond is a bond issued by an institution for the purpose of refinancing the bonds already issued by that institution. The bond issuer uses the money earned from the refunding transaction to buy low-risk, government securities and then puts the money earned from the securities in escrow. This escrow account is then used to pay off the debt on the outstanding bonds. By making use of the refunding bond, the issuer is then released from the debt of those bonds, but still has to come up with the payments for the newly issued refunding bond.
Many institutions, from governments to large corporations, use bonds as a way to raise funds for different financial needs. A bond is simply a loan issued from an institution to an investor, who receives his principal back at the end of the bond term along with regular interest payments. Market interest rates are subject to change, and an institution can occasionally find itself in a position where the bond it has issued may not be competitive with current rates. At that point, the bond issuer may consider a refunding bond as a way to rectify the problem.
When a company issues a refunding bond, it essentially can take the money earned from the new issue and turn it into no-risk profit by purchasing government securities. This money is placed in an escrow account to pay off the existing bonds already issued to investors. These outstanding bonds are now considered the refunded bonds, while the newly-issued bonds become the debt obligation of the issuer.
There are a few different reasons that a company or institution may want to consider the option of a refunding bond. Lower interest rates are one obvious reason. With the lower rates obtained on the newly issued bond, the company can actually net a profit from the difference between the refunding and refunded bonds. It is important to note that strict tax laws adhere to this type of transaction, which is known as high-to-low refunding.
In addition, there are some cases when an institution may wish to consider a refunding bond even if the current interest rates are higher than the rates of the existing bond. An institution may wish to get out of a certain contract stipulated by the existing bonds, or it may simply be trying to restructure its debt. The resulting transaction, known as low-to-high refunding, will not earn the issuer a profit in the short term, but it could be a useful financial maneuver in terms of future implications.