Refinancing risk is the risk that a borrower will be unable to secure new debt to replace an existing debt obligation, potentially leading to financial losses. This risk is particularly relevant for businesses, organizations, or individuals who need to obtain new debt to meet their existing debt obligations as they come due. If these borrowers are unable to find new sources of debt, they may face financial losses, such as the need to shut down a profitable business. The following are a few examples of refinancing risk.
Short Term Debt
A house builder takes on large amounts of short term debt to fund its projects. The company must regularly replace this debt with new debt. This strategy works for several years until credit markets suddenly tighten and banks become unwilling to offer new debt to the company. As a result, the builder needs to sell some of its properties at a large discount in order to quickly raise money to cover its short term debt obligations. This results in a sizable financial loss.
Long Term Debt
An electronics company makes a large offering of 5 year bonds. The bonds are structured with small payments in the first four years followed by large balloon payments in the last year. The company assumes that it will be able to make these balloon payments with new bond issues. When the balloon payments come due the company has a failed product launch that damages its profitability and financial condition. The company is unable to find financing to cover the balloon payments and must issue new equity at a discount to market prices. Its stock price plunges dramatically as existing shareholders are diluted by the issuance of new shares.
