Definition
Defeasance is a financial strategy in which a borrower secures additional collateral to repay a loan, effectively “defeating” the loan’s terms. This strategy is typically used to refinance debt or reallocate assets within a company. The original collateral is replaced with a bond or other interest-yielding asset, which will generate income to pay off the debt.
Key Takeaways
- Defeasance is a financial strategy whereby a borrower sets aside enough cash or bonds to service a debt such as a mortgage or a bond issuance. When the debt is defeased, it’s effectively considered paid off for accounting purposes, reducing the borrower’s total liabilities.
- In a defeasance, the debtor transfers risk to a third party. Once the required assets are set aside, the debtor is no longer responsible for any default risk related to the debt. This risk is transferred to those who own the assets set aside to service the debt.
- Though defeasance reduces the borrower’s liabilities and transfers risk, it’s not without costs. The process itself requires the borrower to put up sufficient collateral to cover the debt, often creating liquidity challenges. It also incurs transaction costs and can be a complex procedure requiring legal, financial, and perhaps real estate expertise.
Importance
Defeasance is a crucial financial term because it refers to a method through which a borrower can be released from the obligations of their debt.
This procedure is done by setting aside sufficient assets (either cash or securities) to service the debt in a trust.
Its importance lies in the fact that this approach presents a beneficial strategy for the borrower to effectively negate the liabilities on their balance sheet, improve creditworthiness, and perhaps obtain better loan terms in the future.
This tool is also significant for bondholders as it ensures the repayment of the principal and interest, thereby reducing their risk.
Therefore, defeasance plays a vital role in enhancing financial flexibility and security within debt management.
Explanation
Defeasance is primarily used in the realm of finance as a strategy to eliminate liabilities off the balance sheet. More often found in the context of commercial real estate and corporate finance, this procedure involves substituting the initial responsibilities with other assets, usually of similar value.
The purpose of defeasance is to permit borrowers to effectively release themselves from debt obligations, essentially by providing equivalent collateral to their lenders. In practice, this method is often leveraged by corporations to remove debt from their financial statements, improving their debt to equity ratio and subsequently increasing their borrowing capacity.
Additionally, it is also a tool usually employed in securitized and public debt issues for the benefit of bondholders. Defeasance ensures lenders or bondholders continue to receive the agreed-upon interest and principal payments on schedule even if the original borrower is unable to fulfill these responsibilities, thereby adding an additional layer of security to the lending process.
Examples of Defeasance
Commercial Real Estate Loans: One of the most common real estate industry applications of defeasance occurs when a property owner wants to refinance or sell their property before the end of their existing commercial mortgage-backed securities loan. This form of loan often contains prepayment restrictions or significant penalties. Through defeasance, the borrower can release themselves from the initial agreement. They effectively replace the original collateral (the property) with low-risk government securities, such as Treasury bonds, that will continue to cover the principal and interest obligations of the loan.
Municipal Bonds: Local or state governments often use defeasance as a mechanism to retire their existing debt obligations from municipal bonds. The issuer establishes an escrow account with enough low-risk securities to cover remaining payments. This allows them to remove the liability from their books while ensuring investors receive their due payments. The government entity can then potentially issue new bonds at a lower interest rate, saving public money.
Corporate Debt Restructuring: If a company has a corporate bond outstanding and interest rates fall significantly, the company might choose to go through a defeasance process to replace the original bond with low-risk government securities. The company would acquire these securities and place them in a trust. The cash flows from these securities would then cover the remaining interest and principal on the bond, essentially removing the liability from the corporation’s balance sheet and replacing it with a lower-interest debt.
Defeasance FAQ
1. What is Defeasance?
Defeasance is a provision in a contract that voids a bond or loan on a balance sheet if the borrower sets aside cash or bonds sufficient enough to service the borrower’s debt. The borrower is effectively defeasing or negating the loan or bond liability, rendering it null and void.
2. What is the purpose of Defeasance?
Defeasance is a tool used by corporations and governments to reduce the value of their outstanding liabilities on their balance sheets. By offsetting debt with cash or other assets, the borrower effectively reduces their outstanding debt, which can improve their credit rating and provide other financial benefits.
3. What are the types of Defeasance?
There are two types of defeasance – legal and in-substance. Legal defeasance is where the debt is legally satisfied and removed from the balance sheet based on specific provisions in the debt agreement. In-substance defeasance, on the other hand, involves the borrower setting aside assets to repay the debt but the liability still remains on the balance sheet.
4. How does Defeasance affect interest rates?
Defeasance has a complex relationship with interest rates. If a borrower chooses to defease their bonds or loans when interest rates are low, they can replace their existing high-interest rate debt with low-interest rate marketable securities. This can significantly reduce their interest payments over the life of the loan.
5. What is the role of Escrow in Defeasance?
In most instances of defeasance, the borrower would place the cash or bonds into an escrow account, which is set up by a third-party escrow agent. The funds in the escrow account are then used to service the debt, effectively reducing the borrower’s outstanding obligations.
Related Entrepreneurship Terms
- Securitization
- Collateral
- Sinking Fund
- Debt Service
- Call Provision
Sources for More Information
- Investopedia: A leading financial education platform that provides extensive definitions, examples, and articles about finance terms such as defeasance.
- Money-Zine: Offers comprehensive information focusing on personal finance, career development, and investing – including details on principles like defeasance.
- Corporate Finance Institute: Provides online courses and educational materials about various finance topics, including defeasance.
- Yahoo Finance: A comprehensive finance platform that provides news, stock market data, as well as resources on financial concepts such as defeasance.
