Understanding current and advance refundings.

• Author: Jordan, Larry

The interest and issuance costs of refunding.

With interest rates in the municipal bond market approaching the low point in recent history, many government finance officers are being bombarded with proposals to refund their outstanding bonds. Unfortunately, refundings are not widely understood, although they are widely utilized.

This article discusses current and advance refundings and explains the mechanics of refundings. The article also focuses on the three components of an advance refunding transaction; the refunded bonds, the escrow account and the refunding bonds.

In a refunding issue, the proceeds of a refunding (new) issue are used to retire a refunded (old) issue. A refunding issue is usually done to restructure debt, to revise covenants, to realize savings or to achieve several of these objectives. Savings result when the debt service on the refunding issue is lower than the debt service on the refunded issue.

On refundings motivated by debt restructuring, most financial advisors recommend a refunding when it will avoid a default or preclude an unmanageable tax or rate increase. On refundings motivated by covenant revision, most financial advisors recommend a refunding when it will eliminate bond covenants which impede the issuer's ability to construct facilities or provide services.

Due to escrow considerations and issuance costs, the refunding issue will typically have a larger principal amount than the refunded issue, which produces a loss from an accounting standpoint, even if the transaction produces savings from an economic standpoint.

Current Refundings

A current refunding occurs when the (old) refunded issue is retired within 90 days after the refunding (new) issue is sold. Proceeds of the refunding issue are used to purchase the refunded bonds from investors at the maturity date or at a call date prior to the maturity date.

A current refunding is less complicated and less costly than an advance refunding, since a current refunding does not require that the issuer establish an escrow account, hire a paying agent/registrar to administer the escrow account, obtain bond ratings on the refunded issue or verify the cash flow in the escrow account.

Most financial advisors will recommend that an issuer pursue a current refunding whenever it produces savings, since the only costs consist of the nuisance cost in the differences between the old tax law and the new tax law and the opportunity cost in the differences between the old call flexibility and the new call protection.

Advance Refundings

An advance refunding occurs when the refunded bonds are retired more than 90 days after the refunding bonds are sold. Proceeds of the refunding issue are used to buy U.S. government securities, which are held in an escrow account until funds are needed to pay interest on the refunded bonds and to purchase the refunded bonds from investors at the maturity date or at a call date prior to the maturity date.

Prior to the 1986 tax reform act, an issuer could realize savings by refunding old "low coupon" bonds with new "high coupon" bonds. In a "low to high" advance refunding, the "minor portion," which could equal up to 15 percent of the original refunded issue, could be invested in the escrow account at an unrestricted yield. Also, the refunded issue could be escrowed to the maturity date, rather than to the call date, which maximized this legal "arbitrage."

After 1986, an issuer can only realize savings by refunding old "high coupon" bonds with new low coupon" bonds. In a "high to low" advance...