Current Refunding

What Is Current Refunding?

Current refunding is a public finance and debt management strategy where an issuer refinances existing bond debt by issuing new bonds, with the proceeds used to retire the older bonds within a short, specified timeframe, typically 90 days or less from the issuance of the new bonds. This process allows governments and other public entities to capitalize on favorable market conditions, such as declining interest rates, to reduce their borrowing cost of capital or to modify restrictive covenants associated with the original debt³⁶, ³⁷. A current refunding directly pays off the existing bonds shortly after the new bonds are sold, as opposed to setting up an escrow for future payment³⁴, ³⁵.

History and Origin

The practice of refunding debt, which includes current refunding, has been a long-standing tool for governments and corporations to manage their financial obligations. Its prevalence increased as capital markets developed and issuers gained the ability to issue callable bonds, allowing them to redeem outstanding debt before its stated maturity date. The ability to refinance debt became especially valuable during periods of significant interest rate volatility or decline. For instance, a substantial amount of long-term debt issuance, often exceeding 50% in some years, has involved refunding existing outstanding debt to achieve cost savings³³. In recent times, large volumes of municipal bond refunding have been observed when market conditions are opportune for issuers to reduce their interest expenses³². The Municipal Securities Rulemaking Board (MSRB), which regulates the municipal securities market, provides resources for investors to understand refunding bonds and their characteristics³¹.

Key Takeaways

• Current refunding involves issuing new bonds to pay off existing debt within 90 days.³⁰
• The primary goal is typically to achieve interest cost savings by taking advantage of lower market interest rates.²⁹
• Issuers may also use current refunding to remove undesirable restrictive covenants from older bond indentures.
• Unlike advance refunding, there are no federal limitations on the number of times a bond issue can be current refunded on a tax-exempt basis.²⁸
• The decision to undertake a current refunding usually involves a detailed analysis of potential present value savings against the costs of issuance.²⁷

Formula and Calculation

While there isn't a single "formula" for current refunding itself, the financial decision to undertake it is driven by the calculation of present value savings. Issuers aim to achieve a positive net present value (NPV) savings, which means the present value of the debt service payments on the new bonds is less than the present value of the remaining debt service payments on the old bonds, after accounting for all transaction costs.

The core calculation involves comparing the total debt service (principal and interest payments) of the outstanding bonds to the total debt service of the new refunding bonds.

$\text{Present Value Savings} = PV(\text{Old Debt Service Payments}) - PV(\text{New Debt Service Payments}) - \text{Issuance Costs}$

Where:

• (PV(\text{Old Debt Service Payments})) = Present value of all future principal and interest rates payments on the original bonds.
• (PV(\text{New Debt Service Payments})) = Present value of all future principal and interest payments on the newly issued refunding bonds.
• (\text{Issuance Costs}) = Fees paid to underwriters, legal counsel, financial advisors, and other administrative expenses associated with issuing the new bonds.

Issuers often establish a minimum present value savings threshold, such as 3% of the refunded principal amount, before proceeding with a current refunding to ensure the transaction yields significant economic benefits.²⁶

Interpreting Current Refunding

Current refunding is interpreted as a proactive refinancing maneuver by an issuer to improve its cash flow and reduce its long-term borrowing costs. When an issuer successfully completes a current refunding, it indicates that prevailing financial markets offer more favorable terms (e.g., lower interest rates) than those embedded in the outstanding debt.

The economic success of a current refunding is typically measured by the net present value (NPV) savings generated. A positive NPV saving signifies a financially beneficial transaction for the issuer, allowing them to free up resources that can be redirected to other budgetary priorities or public services. Conversely, if the market conditions do not provide sufficient savings, or if the costs of the refunding outweigh the benefits, an issuer may opt against it. This strategy is particularly common for municipal bonds, where state and local governments seek to optimize their fiscal health.

Hypothetical Example

Consider the City of Harmony, which issued $50 million in municipal bonds five years ago with a 5% coupon rate. These bonds have five years remaining until maturity and are callable at par. Due to a significant drop in interest rates, the city's credit rating has remained strong, and it can now issue new bonds at a 3% coupon rate.

1. Old Debt: $50,000,000 outstanding principal, 5% annual interest.
2. New Debt: City issues $50,000,000 in new refunding bonds at a 3% annual interest rate.
3. Refunding Action: Within 90 days of issuing the new bonds, the City of Harmony uses the proceeds to pay off the entire outstanding $50,000,000 principal of the old bonds, along with any accrued interest and call premium.

Annual Savings:

• Old annual interest payment: ( $50,000,000 \times 0.05 = $2,500,000 )
• New annual interest payment: ( $50,000,000 \times 0.03 = $1,500,000 )
• Annual interest savings: ( $2,500,000 - $1,500,000 = $1,000,000 )

Over the remaining five years of the original bond's term, the City of Harmony would save $1 million annually in interest payments, leading to significant overall cash flow improvements, assuming the one-time issuance costs of the new bonds are less than the total savings generated.

Practical Applications

Current refunding is a widely used strategy in public finance and debt management, particularly by state and local governments. Its primary applications include:

• Reducing Interest Costs: The most common reason for a current refunding is to capitalize on a decline in market interest rates. By replacing higher-coupon bonds with lower-coupon new issues, governmental issuers can significantly reduce their annual debt service payments. For example, municipal bond volumes often jump when market conditions allow for profitable refunding opportunities²⁵.
• Restructuring Debt Service: Issuers may use current refunding to reconfigure their cash flow obligations, perhaps by shortening or lengthening the maturity schedule to better align with budgetary needs or to achieve level debt service payments over a period²⁴.
• Removing Restrictive Covenants: Older bond indentures might contain covenants that impose limitations on the issuer, such as restrictions on issuing additional debt or maintaining certain financial ratios. Current refunding allows the issuer to replace these bonds with new ones that have more flexible or less onerous terms, enhancing financial flexibility²³.
• Improving Credit Rating: While not a direct goal, reducing debt service costs or restructuring debt effectively can indirectly lead to an improved credit rating for the issuer, making future borrowing cheaper.

Market dynamics, influenced by factors like Federal Reserve policies, continuously affect the viability of such operations. For instance, changes in interest rates can significantly impact debt management strategies for state and local governments²².

Limitations and Criticisms

Despite its advantages, current refunding has several limitations and potential criticisms:

• Interest Rate Dependency: The primary driver for current refunding is a decline in interest rates that makes refinancing economically beneficial. If rates rise or remain stagnant, the opportunity for cost savings diminishes or disappears entirely, making a current refunding unfeasible²⁰, ²¹.
• Issuance Costs: Undertaking a current refunding involves significant upfront costs, including underwriter fees, legal expenses, and other administrative charges. These costs must be carefully weighed against the projected present value savings; if the savings are minimal, the transaction may not be worthwhile¹⁹.
• Call Protection: Many bond issues include a "call protection" period, typically 5 to 10 years, during which the bonds cannot be called or redeemed by the issuer¹⁷, ¹⁸. A current refunding can only occur if the outstanding bonds are callable within 90 days, limiting flexibility and potentially forcing issuers to wait for future market opportunities¹⁶.
• Market Access Risk: While generally lower for current refundings than for advance refundings, there is always a risk that market access or favorable pricing may not be available precisely when the older bonds become callable and a current refunding is desired¹⁵.
• Investor Perception: From an investor perspective, bonds that are pre-refunded or current refunded can sometimes be perceived differently, especially regarding their future yield potential or specific call features. Understanding these nuances is crucial for bondholders¹⁴.

Concerns about the economic rationality of some refunding activities have been raised, with some research indicating that not all such transactions generate the expected positive economic outcomes¹², ¹³.

Current Refunding vs. Advance Refunding

Current refunding and advance refunding are both strategies for debt refinancing, primarily distinguished by the timing of the bond redemption relative to the new bond issuance.

In current refunding, the proceeds from the new refunding bonds are used to pay off the outstanding bonds within a short period, typically 90 days or less from the issuance date of the new bonds¹⁰, ¹¹. This means the old bonds are retired almost immediately. The primary motivation for current refunding is often to seize immediate opportunities to lower interest rates or modify bond covenants. There are no federal limitations on the number of times a bond issue can be current refunded on a tax-exempt basis⁹.

In contrast, advance refunding occurs when the new refunding bonds are issued more than 90 days before the outstanding bonds are paid off⁷, ⁸. In an advance refunding, the proceeds from the new bond issue are typically placed in an escrow account, invested in U.S. government securities, which then generate income to pay the debt service on the old bonds until their call date or maturity⁵, ⁶. A significant change occurred with the Tax Cuts and Jobs Act of 2017, which eliminated the ability for state and local governments to issue tax-exempt advance refunding bonds after December 31, 2017², ³, ⁴. Issuers may still conduct taxable advance refundings, but the favorable tax treatment is lost. The key difference lies in the timing: immediate payment for current refunding versus a delayed payment via an escrow for advance refunding.

FAQs

What is the main purpose of current refunding?

The main purpose is for an issuer to reduce its overall interest rates expense by replacing existing, higher-cost bond debt with new bonds issued at lower prevailing rates. It can also be used to eliminate restrictive covenants on the old bonds.

Is current refunding only for governments?

While most commonly associated with municipal bonds issued by state and local governments, corporations can also engage in current refunding for their outstanding corporate bonds, particularly if those bonds are callable bonds.

What is the "90-day rule" in current refunding?

The "90-day rule" refers to the stipulation that for a refunding to be considered a "current refunding," the proceeds from the new bonds must be used to retire the old bonds within 90 days of the new bonds' issuance. If the retirement occurs after 90 days, it is classified as an advance refunding.¹

Does current refunding guarantee savings?

No, it does not guarantee savings. While the intent is to reduce costs, the actual savings depend on market interest rates at the time of the refunding, as well as the various fees and expenses associated with issuing the new bonds. Issuers typically perform a detailed present value analysis to determine if sufficient savings can be achieved.