Refunding Bonds

Summary

A refunding bond issue is one whose proceeds are used to retire the outstanding debt of a prior bond issue.

Advantages

• Refunding bonds can result in savings if the interest rate on the new bonds is lower than the interest rate on the existing bonds.
• Refunding bonds can be used to remove restrictive bond covenants that apply to existing bonds.
• Governments can use refunding bonds to restructure debt service payments.

Disadvantages

• Refunding bonds have the same types of issuance costs as a new issue, thus the government in essence repeats these costs during the life of the debt.
• Advance refundings can be done only once during the life of a bond, so the issuer must identify the most advantageous time to refund.
• Advance refundings are not allowed for private activity bonds.

Refunding Bonds

A refunding bond is a type of bond whose proceeds are used to retire the outstanding debt of a prior bond issue. Refunding is done for several reasons: to take advantage of lower interest rates; to restructure debt service; or to remove old bond covenants that are too restrictive.

• Lower interest rates are the most common reason for refunding. This is sometimes referred to as a high-to-low refunding because of the conversion from a high interest rate bond to a low interest rate bond.
• Refunding to restructure debt service is often used by a government during a recession in order to defer or stretch out debt service obligations until its financial situation improves.
• Refunding to remove debt covenant restrictions is most common for revenue bonds because general obligation bonds usually have few meaningful restrictions.

Bonds issued within 90 days of the call date of the outstanding bonds are called "current refunding bonds." If the bonds are issued more than 90 days in advance of the call date, the bonds are called "advance refunding bonds." There are numerous federal restrictions on the use of advance refunding bonds because of arbitrage earnings restrictions. There are relatively few limits on current refundings.

The Refunding Process

After the sale of the refunding bonds, the proceeds are held in an escrow account until the prior bonds are called. New bonds are issued in an amount sufficient to cover the principal, interest, and call premium of the prior bond issue. If the proceeds are invested in secure investment vehicles the original bonds are considered "defeased" and they are no longer considered a liability of the issuer.

Secure investments include cash, U.S. Treasury notes, or other obligations guaranteed by the U.S. government. Additionally, the rating on the original bonds is upgraded to AAA, since there is a guaranteed source of repayment. The escrow fund is used to meet debt service obligations of the original bond issue until the call date, at which time the remainder of the escrow fund is used to redeem the outstanding bonds.

Refunding issues do not have to go through the same approval process as the original bonds since the original bond issue was already approved. There is no limit as to how far in advance refunding bonds can be issued. Refunding issues are typically sold through a negotiated sale because of their complexity.

Bond issuers generally target a level of present value savings, measured as a percentage of the refunded bond issue as a guideline for determining when to issue refunding bonds. For example, 4% or 5% is a common target. The amount of money saved from refunding depends on several factors, including:

• the difference between the prior and new bond interest rates;
• the maturity date of the prior bonds;
• the call date on the prior bonds;
• the yield on escrow investments;
• the call premium on prior bonds; and
• the costs of issuance for the refunding bonds.

The earlier a bond issue is refunded, the greater the issuer's savings. Once the first call date on a bond issue has passed, an increasingly lower current interest rate is required on the refunding bonds to achieve a target level of savings. Smaller issues or specific maturities of an issue may not be worth refunding, even if the percent savings targets are achieved, if the absolute dollar savings are insufficient to justify the time, expense, and effort of executing a refunding issue.

To assist in analyzing the benefit of refunding, click on the following refunding calculator.