What is Advance Refunding
Advance refunding refers to when one bond issuance is used to pay off another outstanding bond. The issue of the new bond is at a lower interest rate than the older, unpaid obligation. Municipalities typically use advance refunding to lower borrowing costs and to take advantage of lower interest rates. Advance refunding can also refer to a bond issuance in which new bonds sell at a lower rate than the outstanding ones. The bond's originator invests the proceeds from the sell, then when calling the older bond investors are paid using the invested proceeds.
BREAKING DOWN Advance Refunding
Advance refunding is most often used by governments seeking to postpone their debt payments rather than having to pay off a large amount of debt in the present. In some ways, this is comparable to a homeowner’s mortgage refinance. In 2017, advance refunding bonds totaled $91 billion and comprised 22.2 percent of the $3.8 trillion total municipal bond market.
Regulators have shown some concern over potential abuses of advance refunding. Since municipal bonds tend to have lower rates, municipalities could potentially use advance refunding to issue unlimited amounts of debt at low rates. The city would then invest in higher rate investments. For this reason, regulators have imposed rules that limit the tax-exempt status of the interest on refunding bonds. Furthermore, because of a provision in the Tax Cuts and Jobs Act of 2017, interest income is not tax-exempt for advance refunding bonds issued after December 31, 2017.
Individual states have laws that impose limits on advance refunding, such as statutory maturities and interest rate limits. The IRS restricts the yield earnings on investments from an advance refunding bond issue. Additionally, arbitrage regulations typically permit municipalities to advance refund bonds one time over the bond’s lifetime. Before initiating advance refunding, cities must first ensure that the amount of money to be saved through the transaction is worth any costs of issuance.
Example of Advance Refunding
Advance refunding is popular in low-interest rate environments, when bond issuers may seek to take advantage of lower rates by refinancing outstanding bonds that have not yet matured. For example, suppose a municipality wants to refinance its current unpaid bonds at a new, lesser rate. The city would take the proceeds from the sale of the refunding bonds and invest them in U.S. Treasuries (t-Bonds) or other taxable government securities. The Treasuries are then deposited into an escrow portfolio. The principal and interest on the Treasuries in the escrow portfolio are used to pay off the old bonds.