DEFINITION of Pre-Funded Bond
A pre-funded bond is a municipal bond backed by Treasury securities deposited in an escrow account. Pre-funded bonds are issued by municipalities that wish to attain a higher credit rating for their debt. Since state-issued bonds are not pledged by the full faith of the U.S government, the underlying collateral minimizes the risk of default.
BREAKING DOWN Pre-Funded Bond
The credit quality of a bond is determined by the level of risk the bond is perceived to have. A lower risk bond will have a higher credit quality and, thus, a higher credit rating than a higher risk bond. Investors are more drawn to higher rated bonds given that these bonds have a lower risk of default. To incentivize lenders and investors to purchase a bond issuer, a municipality may issue pre-funded bonds.
Pre-funded bonds are bonds which have their interest and principal obligations guaranteed by risk-free securities in an escrow account. Investors are more likely to purchase this bond since there is a dedicated revenue source already in place for coupon payments. The bond issuer is not required to generate cash flow to fulfill its payment obligations on the bond as the payment is made through the escrow account. The escrow is collateralized by risk-free Treasury securities, such as Treasury bills, which generate interest that is used to pay the coupons. The pre-funded bond and the U.S. securities tend to have the same maturity. The risk-free interest payment allows the issuing entity to set a lower coupon rate on the bond than the rate on a comparable zero-coupon bond. Thus, municipal bond issuers benefit from pre-refunding by reducing their long-term borrowing costs.
Some pre-funded bonds are defeased securities, that is, no longer recognized on the issuer’s balance sheet. Instead, the debt obligation is transferred from the issuer to the escrow fund. The securities used as collateral are sufficient to meet all payments of principal and interest on the outstanding bonds as they become due. If for some reason, the funds used for defeasance prove insufficient to fulfill the future payment of the outstanding debt, the issuer would continue to be legally obligated to make payment on such debt from the pledged revenues. Pre-funded bonds that are defeased will have a provision in the escrow agreement requiring issuer on the pre-funded bonds to make up any shortfall in the escrow account, but this is unlikely.
The price of pre-funded bonds fluctuates with movements in market rates. The bonds have reinvestment risk but default-free coupon payments. Pre-funded bonds provide the tax advantages present in regular municipal bonds, but are exposed to less risks. The federal government-based collateral reduces the potential for the issuer's credit to deteriorate. Still, pre-funded bonds are usually rated as junk bonds given that they are sold primarily by entities that have little to no cash flow. If the funds in the escrow are tapped out before the bond matures and the issuer does not have enough cash to pick up the bond payments, there is a risk that the issuer could default. With the pre-funded structure, a company incurs the additional cost of creating the escrow fund and the underwriting fees on the escrowed money.