What is Debt Retirement?

Debt retirement occurs when a borrower repays the principal associated with a bond or note. An issuer should have a firm plan in place for debt retirement, in order to reassure investors about its ability to do so. An issuer that builds a history of reliably being able to retire its debt on time is seen as being low-risk, and so may be able to issue additional debt at a comparatively low interest rate.

Debt Retirement Alternatives

A conservative way to accomplish debt retirement is to create a sinking fund when a debt is initially created, and make ongoing contributions to the sinking fund. By the maturity date of the debt, the amount in the sinking fund is sufficiently large to pay for most or all of the debt retirement. Debt may also be retired by incurring a new debt and using the resulting funds to pay off the old debt. A third approach is to issue serial bonds, where the bonds mature on different dates, allowing for a staggered repayment schedule.

When to Retire Debt

There are several cases in which it can make sense to retire debt before its maturity date. The most obvious one is when the interest rate on the debt is higher than the current market interest rate. In this case, the borrower should take out a new loan at the current (lower) rate and use the funds to pay off the existing, higher-cost loan. Another scenario for debt retirement is when the existing loan has oppressive debt covenants associated with it. In this case, it can make sense to retire the debt and replace it with a new debt agreement that contains more lenient covenants.