Debt Restructuring: When Do Loan and Bond Prepayments Pay Off?

Many debtholders, whether private households, companies, or states, are caught up in high-interest long-term loans. At the same time, economic developments over the past few years have created a low-interest rate environment in which prepaying an existing loan and simultaneously refinancing into a new loan can be advantageous. By redeeming an existing loan before maturity and refinancing into a loan with a lower interest rate, the amount of interest owed to the lender can be reduced significantly, potentially saving thousands of euros in the long term. Similar considerations hold for prepaying callable bonds since these bonds are in practice a kind of securitized loan. A callable bond is a debt security that allows the issuer to redeem the bond prior to its maturity.

In our paper, we first describe the factors that have made debt restructuring worthwhile. These include the general past economic development, the evolution of lending rates, the current interest rate landscape and market expectations, as well as European prepayment regulations. The main part of our paper is a subsequent assessment of the circumstances under which loan and bond prepayments make sense for debtholders.

Intuitively, debt restructuring may seem advantageous whenever the nominal interest rate of the new loan is lower. However, debt restructuring entails transaction costs: in consequence, additional factors need to be taken into account when evaluating whether a prepayment is worthwhile. Transaction costs include a possible ‘prepayment penalty’ for the early redemption of the existing loan, and a possible loan disbursement fee for taking out a new loan. When considering bond prepayments, exercising the right to call a callable bond and simultaneously issuing a new bond will also generate transaction costs.

At the moment, interest rates in the Euro area are at an all-time low and have been so for quite some time. However, the market seems to anticipate that interest rates, and in consequence lending rates, will begin to rise in the (near) future. This implies that an analysis on whether or not to restructure one’s debt should be undertaken now in order to lock in the lowest possible interest rate for the new debt contract.

Although this topic is without doubt highly relevant and affects companies, states, and private individuals alike, academic literature in this field is scarce to almost non-existing. Mainstream media do seem to have caught onto the subject; however, articles fail to provide theoretic foundations for their assertions and recommendations. On these grounds, we examine in detail under which circumstances loan and bond prepayments make sense for debtholders, providing a principled solution for determining an upper limit on the nominal interest rate of the new loan up to which prepaying the old loan and refinancing into a new low pays off. We specify an exact solution as well as a rule-of-thumb approximation for the most common debt restructuring scenarios, taking into account the different payment modalities of the debt instruments as well as how the transaction costs incurred are to be financed. The focus of our paper is on the mathematical conditions for switching loans.

Edwin O. Fischer is a Professor of Business Administration at the Institute of Finance, University of Graz.

Ines Wöckl is a PhD Candidate and research assistant at the Institute of Finance, University of Graz.

This post was originally published on the Harvard Law School Bankruptcy Roundtable.