Advance refunding

What Is Advance Refunding?

Advance refunding is a financial strategy employed by bond issuers, typically state and local governments, to refinance existing debt more than 90 days before the outstanding bond's first optional call date or maturity date. This practice falls under the broader category of public finance and debt management. Issuers undertake an advance refunding primarily to reduce future debt service costs by taking advantage of lower market interest rates. The proceeds from the new bond issuance are placed into an escrow account, often invested in U.S. Treasury securities, to pay the principal and interest on the original bonds until they can be formally redeemed. The concept of advance refunding allows an entity to proactively manage its liabilities, even if the existing bonds are not yet immediately callable.

History and Origin

The practice of advance refunding has a long history in the municipal bonds market. Before the Tax Reform Act of 1986, state and local governments had greater flexibility, with some able to issue an unlimited number of advance refunding bonds for a single issue. This allowed them to refinance even for minimal cost savings⁴⁵. However, the Internal Revenue Code (IRC) Section 103, which governs the tax-exempt status of interest on state and local bonds, has seen significant changes over time⁴⁴.

The Tax Reform Act of 1986 introduced limitations, generally permitting only one tax-exempt advance refunding per bond issue after 1985⁴³. This was aimed at preventing excessive or abusive uses of the mechanism and limiting the number of federal subsidies existing concurrently for the same financed assets⁴². The most significant recent change occurred with the Tax Cuts and Jobs Act (TCJA) of 2017. Effective January 1, 2018, the TCJA repealed the exclusion from gross income for interest on bonds issued to advance refund another bond, effectively eliminating the ability to issue new tax-exempt bonds for advance refunding purposes⁴⁰, ⁴¹. This legislative change aimed to increase federal tax revenues, with estimates suggesting savings of over $16 billion over a decade³⁹. While tax-exempt advance refundings are no longer permitted, issuers can still perform taxable advance refundings, though these typically come with higher interest costs³⁷, ³⁸. Organizations like the Government Finance Officers Association (GFOA) have advocated for the reinstatement of tax-exempt advance refunding, highlighting the significant cost savings it provided to state and local governments prior to 2018³⁵, ³⁶.

Key Takeaways

• Advance refunding is a debt management technique where new bonds are issued to pay off existing bonds more than 90 days before the original bonds' call or maturity date.
• The primary motivation for advance refunding is to capitalize on lower interest rates, thereby reducing future debt service costs.
• The proceeds from the new bonds are typically held in an escrow account, invested in U.S. Treasury securities, to cover payments on the old bonds until they are redeemed.
• Since the Tax Cuts and Jobs Act of 2017, the issuance of tax-exempt advance refunding bonds has been prohibited in the United States, though taxable advance refundings are still possible.
• While offering potential savings, advance refunding can also involve costs, such as negative arbitrage and issuance fees, which must be carefully considered.

Formula and Calculation

The core benefit of an advance refunding, particularly when it was tax-exempt, was the generation of present value savings. The calculation involves comparing the net present value of the original debt service stream with the net present value of the new debt service stream plus the cost of the escrow.

The general concept of savings from a refunding can be expressed as:

Where:

• (\text{NPV (Old Debt Service)}) = Net present value of all future principal and interest payments on the original bonds.
• (\text{NPV (New Debt Service + Escrow Costs)}) = Net present value of all future principal and interest payments on the new refunding bonds, plus any costs associated with setting up and maintaining the escrow account.

A transaction is generally considered economically beneficial if the total savings are positive. For advance refundings, the escrow account's investment earnings on the proceeds of the new bonds were traditionally limited, often to a yield not exceeding the yield of the new refunding bonds, to prevent arbitrage abuses³⁴.

Interpreting Advance Refunding

Interpreting an advance refunding involves understanding its impact on an issuer's financial obligations and future flexibility. When an issuer undertakes refinancing through an advance refunding, it aims to lower its overall borrowing costs by securing a lower yield on the new bonds compared to the original issuance. This can free up budgetary capacity for other purposes or allow for faster repayment of debt.

However, the interpretation also considers the trade-offs. Prior to the 2017 tax law changes, tax-exempt advance refundings could offer substantial savings, but they effectively meant incurring new debt to pay off old debt at a later date, involving an escrow period where both sets of bonds were outstanding³², ³³. The benefit was realized through the interest rate differential. For instance, if a municipality issued bonds at 5% and interest rates dropped to 3%, an advance refunding could lock in those lower rates, even if the original bonds weren't yet eligible for a direct call. The economic analysis would focus on whether the present value of the anticipated savings outweighed the costs of issuance and the potential negative arbitrage on the escrowed funds³⁰, ³¹.

Hypothetical Example

Consider the City of Maplewood, which issued $50 million in municipal bonds five years ago with a 5% coupon rate and a 10-year optional callable bond feature. This means the earliest the City could call these bonds without penalty is in five more years. Due to favorable market conditions, current interest rates have dropped significantly. The City's financial advisors identify an opportunity to issue new bonds at a 3% coupon rate.

Since the original bonds are not callable for another five years (more than 90 days), the City decides to perform an advance refunding. Here's how it would generally work:

1. Issue New Bonds: The City issues $50 million of new refunding bonds at the lower 3% interest rate.
2. Establish Escrow: The proceeds from the new bond sale are deposited into an irrevocable escrow account. This account is typically invested in U.S. Treasury securities or other high-grade investments.
3. Future Payments Secured: The principal and interest earned on the investments within the escrow account are precisely structured to cover all future debt service payments on the original 5% bonds until their optional call date in five years.
4. Original Bonds Defeased: Once the escrow account is fully funded and legally structured, the original 5% bonds are considered "defeased" or legally retired from the City's balance sheet, even though the actual bondholders continue to receive payments from the escrow account²⁷, ²⁸, ²⁹.
5. Call Original Bonds: In five years, on the original bonds' optional call date, the funds from the escrow account are used to redeem the remaining principal of the 5% bonds. From that point forward, the City is only responsible for the debt service on the new 3% refunding bonds.

This hypothetical example illustrates how the City of Maplewood uses advance refunding to lock in lower interest rates immediately, even though the original debt cannot be directly paid off for several years.

Practical Applications

Advance refunding, particularly in its tax-exempt form prior to 2018, was a widely used tool in public finance for state and local governments. Its primary application was to achieve significant interest cost savings. According to the Government Finance Officers Association (GFOA), between 2012 and 2017, there were over 9,000 advance refunding issuances nationwide, resulting in over $14 billion in savings for taxpayers on a present value basis²⁶. This allowed municipalities to reduce their financial burden and reallocate resources towards other public services or infrastructure projects.

Beyond pure interest rate savings, advance refunding also provided issuers with a mechanism for:

• Debt Restructuring: It allowed governments to smooth out future debt service payments, alleviate budget pressures, or modify restrictive bond covenants associated with older debt²⁵. This flexibility was crucial for long-term financial planning.
• Capital Project Financing: By freeing up funds through lower interest expenses, municipalities could enhance their capacity to finance new capital projects without increasing overall tax burdens.
• Market Access: For certain issuers, being able to engage in advance refunding meant they could take advantage of favorable conditions in the bond market even if their older bonds were not yet callable, ensuring they didn't miss opportunities for savings²⁴.

While the Tax Cuts and Jobs Act of 2017 eliminated the federal tax-exempt status for new advance refundings of municipal bonds, state and local governments can still perform taxable advance refundings, albeit at a higher cost²², ²³. Efforts continue by organizations like the GFOA to reinstate tax-exempt advance refunding authority, emphasizing its importance as a cost-saving tool for communities across the United States²¹.

Limitations and Criticisms

Despite its potential benefits, advance refunding, particularly tax-exempt advance refunding, faced several limitations and criticisms before its federal prohibition in 2018. One major criticism highlighted by academic research is that advance refunding can, under certain conditions, destroy value for the issuer. This occurs because by pre-committing to call bonds, the issuer effectively surrenders the value of the call option that was embedded in the original bonds¹⁹, ²⁰. For example, if interest rates were to rise significantly after an advance refunding but before the original call date, the issuer would have lost the flexibility to not call the bonds and continue paying the higher rate if it became economically advantageous to do so. Researchers found that the average option value lost could be as much as 1% of the par value, not including fees¹⁸.

Other limitations and criticisms included:

• Negative Arbitrage: During the escrow period, the proceeds from the new bonds are invested. If the yield on these escrow investments is lower than the yield on the new refunding bonds, the issuer experiences "negative arbitrage." This loss reduces the overall savings from the transaction¹⁷.
• Issuance Costs: Advance refundings involve significant transaction costs, including underwriting fees, legal fees, and financial advisory fees to financial intermediaries. These costs can erode a portion of the interest savings¹⁶.
• One-Time Opportunity (Pre-2018): Prior to 2018, the Internal Revenue Service (IRS) generally permitted only one tax-exempt advance refunding per bond issue after 1985¹⁴, ¹⁵. This restriction meant that issuers had to be judicious in deciding when to use this opportunity, as they couldn't repeatedly refinance the same debt on a tax-exempt basis.
• Complexity and Transparency: Advance refunding transactions can be complex, involving intricate escrow structures and calculations. Critics argued that this complexity could obscure the true economic impact and might be used by financially constrained municipalities to create short-term budget relief at the expense of higher future payments¹³.

The elimination of federal tax-exempt advance refundings in 2018 by the Tax Cuts and Jobs Act effectively removed these specific criticisms related to tax-exempt status, while also limiting a tool that many state and local governments found beneficial for debt management.

Advance Refunding vs. Current Refunding

The key distinction between advance refunding and current refunding lies in the timing relative to the redemption of the original bonds. Both are methods of refinancing existing debt, typically to achieve interest rate savings or modify debt structures.

• Advance Refunding: As discussed, an advance refunding occurs when the new refunding bonds are issued more than 90 days before the original bonds are redeemed or called. The proceeds of the new bonds are placed into an escrow account and invested until the original bonds can be legally called or mature. This means there is a period where both the original bonds and the new refunding bonds are outstanding concurrently, albeit with the original bonds effectively defeased. Prior to 2018, tax-exempt advance refundings were common, allowing issuers to lock in lower interest rates well in advance of a bond's call date. However, since January 1, 2018, federal law generally prohibits tax-exempt advance refundings, meaning new advance refunding issues must be taxable¹¹, ¹².

• Current Refunding: A current refunding occurs when the new refunding bonds are issued within 90 days of the redemption date of the original bonds⁸, ⁹, ¹⁰. In a current refunding, the proceeds from the new bonds are used almost immediately to pay off the outstanding bonds. Because of this short timeframe, there is typically no lengthy escrow period with its associated complexities and potential for negative arbitrage. Current refundings can still be done on a tax-exempt basis if the original bonds were tax-exempt⁷. This makes current refunding a more straightforward and often preferred method if the bond's call date is imminent and favorable market conditions exist.

In essence, advance refunding offered greater flexibility in terms of timing, allowing issuers to act on favorable interest rate environments sooner. Current refunding is a more direct exchange of old debt for new debt once the old debt is nearly callable.

FAQs

Q1: Why would an issuer choose advance refunding if it can still do a current refunding?

A1: Before 2018, tax-exempt advance refunding allowed issuers to seize opportunities in the bond market when interest rates were low, even if their existing bonds were not callable for several years. This helped them lock in savings and manage their debt service more proactively. While tax-exempt advance refunding is no longer available, taxable advance refunding still offers a way to restructure debt ahead of schedule, though the economic benefit is reduced due to higher interest costs⁵, ⁶.

Q2: What happened to tax-exempt advance refunding?

A2: The Tax Cuts and Jobs Act (TCJA) of 2017 eliminated the federal tax exemption for interest on bonds issued for advance refunding purposes, effective January 1, 2018. This means that new advance refunding bonds can no longer be issued on a tax-exempt basis by state and local governments in the United States⁴.

Q3: What is "defeased" debt in an advance refunding?

A3: When an advance refunding occurs, the proceeds from the new bonds are placed into an irrevocable escrow account, typically invested in U.S. Treasury securities. These funds are legally designated to pay off the original bonds until their call date or maturity. Once this escrow is established and meets specific legal and accounting requirements, the original bonds are considered "defeased" or legally retired from the issuer's balance sheet, even though the actual bondholders continue to receive payments from the escrow¹, ², ³. The issuer's direct obligation shifts from the original bondholders to the new refunding bonds.

Q4: Does advance refunding impact an issuer's credit rating?

A4: Typically, a well-executed advance refunding that results in significant present value savings can be viewed positively by credit rating agencies, as it demonstrates prudent debt management and strengthens the issuer's financial position by reducing future interest expenses. However, any transaction with substantial issuance costs or negative arbitrage that erodes savings could be viewed less favorably. The current taxable nature of advance refundings might also impact the overall financial benefit compared to previous tax-exempt versions.