Defeasance

What Is Defeasance?

Defeasance is a financial term that refers to the process of setting aside assets or cash reserves to discharge financial obligations. It commonly involves prepayment or retirement of financial obligations, often observed in fixed-income assets like bonds or mortgages. 

It can give issuers more financial flexibility while giving investors more security and assurance. This is done by setting aside assets or cash reserves that can be used to retire the debt obligation. 

In the case of bonds, the issuer may set aside significant funds or invest in various assets to generate revenue capable of covering the bond's outstanding interest and principal payments.

Defeasance offers issuers greater financial flexibility, allowing them to allocate assets or reserves towards debt repayment, thereby releasing resources for other investments or core business activities.

Advantages of defeasance

It is a financial tactic that can benefit fixed-income securities issuers in several methods. First, it involves setting aside assets or cash reserves to discharge financial obligations, such as bonds or mortgages. Here are some of its advantages:

1. Reduced financial risk

Issuers can greatly lower the risk of default by putting aside assets or cash reserves to pay off a debt obligation. This may increase investor confidence and security, increase the bond's allure, and cut the issuer's cost of capital as a result. 

Ensuring that payments are made on schedule and in full for all debt commitments can also assist in safeguarding the issuer's credit rating.

2. Greater financial flexibility

It can provide issuers greater financial flexibility by freeing up their balance sheet to pursue other financial opportunities or invest in their core business. 

This will be advantageous for enterprises with considerable debt on their balance sheet to lower the debt load and strengthen the financial situation.

3. Improved regulatory compliance

Using it, businesses can comply with legal requirements like those set down by the Financial Accounting Standards Board, which mandates that businesses report certain off-balance sheet activities.

4. Reduced interest expense

Retaining a financial commitment before its maturity date can lower the total amount of interest that must be paid during the obligation's life. As a result, the issuer might save a lot of money, and investors might find the bond more appealing.

5. Simplified debt management

It can also simplify debt management for issuers by consolidating multiple debt obligations into a single instrument. This may ease the administrative load of handling different debt instruments and make managing debt payments easier.

6. Increased investor confidence

Defeasance can boost investor trust by assuring investors that their investment will be fully returned regardless of the issuer's financial situation. This may increase the bond's investor appeal, which may cut the issuer's cost of capital.

It offers several benefits to issuers of fixed-income instruments. It serves as a useful financial tactic for managing debt obligations and achieving long-term financial goals by:

• Lowering financial risk
• Supplying more financial flexibility
• Improving regulatory compliance
• Lowering interest expenses
• Simplifying debt management 
• Boosting investor confidence 

Disadvantages of defeasance

Considering that it might seem an enticing option for many businesses looking to reduce their debt burden, several downsides must be considered before adopting such a strategy. We will talk about some of the primary drawbacks in this article.

1. High transaction costs

It involves a complex set of legal and financial transactions that can be very costly. For example, setting up an escrow account, buying securities, and paying for legal and accounting services can add to a significant expense. 

These high transaction costs may render defeasance impractical for organizations with limited financial resources.

2. Loss of flexibility

Defeasance requires setting aside cash or securities that could be used for other purposes, reducing financial flexibility. This means that an organization may lose some flexibility in managing its finances. 

For instance, if a business saves a substantial amount of its capital for this strategy, it might be unable to fund new initiatives or handle unanticipated financial difficulties.

3. Limited applicability

Defeasance only applies to certain debt instruments, such as bonds with callable provisions, limiting their suitability for other types of debt.

It may not be an option for other types of debt, such as bank loans or leases. This limited applicability may make it an unsuitable strategy for some organizations.

4. Risk of reinvestment

When establishing an escrow account, the organization must invest funds in low-risk securities to ensure availability for retiring the debt obligation.

5. The complexity of accounting treatment

It involves a complex set of legal and financial transactions, making it difficult to account for properly.

For example, the organization must record the securities in the escrow account as assets, even though they are held solely to retire debt. This complexity can pose accounting challenges for organizations implementing this strategy.

6. Negative impact on credit rating

It might have a detrimental influence on a company's credit rating. This is because the business is removing a portion of its debt from its balance sheet, potentially decreasing its perceived creditworthiness.

Additionally, transaction costs may further reduce an organization's credit rating.

These disadvantages include high transaction costs, loss of flexibility, limited applicability, reinvestment risk, the complexity of accounting treatment, and a negative impact on credit rating. 

Defeasance vs. Yield Maintenance vs. Prepayment

Defeasance, prepayment, and yield maintenance are terms used in the finance and investment industries. Each describes a different way to handle debt repayment or loan termination.

Understanding the differences between them can help borrowers and lenders make informed decisions. Let's understand the difference in the table below:

Example of Defeasance

The employment of this procedure by the City of Detroit, which declared bankruptcy in 2013, is one famous example. The city had a sizable amount of unpaid debt at the time, including $ 1.4 billion in pension obligation bonds acquired in 2005-2006.

To address this debt, the city planned to use a defeasance strategy to retire the outstanding POBs early.

Under this plan, the city would set aside assets in a trust to retire the pension obligation bonds while still retaining ownership of the previously used assets as collateral for the original bond issuance.

To implement this plan, the city created a new entity called the Detroit General Retirement System Funding Trust, which issued new bonds to replace the outstanding pension obligation bonds. 

The new bonds were secured by the same collateral as the old bonds but had lower interest rates, resulting in significant cost savings for the city.

The assets kept aside had been allocated to a portfolio of high-quality securities that yielded a better rate of return than the new bonds' interest rate. This resulted in the city being able to earn a surplus that was used to lower the transaction's overall cost.

Interpretation

In this example, the use allowed the City of Detroit to handle its outstanding debt commitments and improve its financial condition.

By retiring the outstanding pension obligation bonds early, the city could reduce its prevailing debt burden and save significant amounts of money on interest payments. 

Furthermore, the city achieved cost savings by utilizing lower-interest new bonds and investing assets allocated for defeasance in high-quality securities. It generated a surplus, thereby enhancing its financial position.

The City of Detroit's situation illustrates how it might be utilized successfully to reduce costs and handle a heavy debt load while still preserving control of priceless assets.

This example emphasizes the significance of meticulous practice and execution when carrying out a defeasance transaction and the possible benefits of embracing this approach in managing debt and monetary restructuring.

Free Resources

To continue learning and advancing your career, check out these additional helpful  WSO resources:

• Asset Financing
• Debt Overhang
• Esoteric Debt
• European Sovereign Debt Crisis
• Nonaccrual Loan