What is a Pre-Refunding Bond

A pre-refunding bond is a type of bond issued to fund another callable bond. With a pre-funding bond, the issuer decides to exercise its right to buy its bonds back before the scheduled maturity date. The proceeds from the issue of the lower yield and/or longer maturing pre-refunding bond will usually be invested in Treasury bills (T-bills) until the scheduled call date of the original bond issue occurs.

BREAKING DOWN Pre-Refunding Bond

A callable bond is one that can be “called” or repurchased from the secondary market by the issuer before the maturity date of the bond. When interest rates in the economy drops, bond issuers have an incentive to repurchase existing bonds which have higher affixed interest payments, and issue new bonds at the lower interest rates in the market. This reduces the issuing entity’s cost of debt in the form of lower coupon payments to bondholders. However, to encourage investors to purchase callable bonds, these bonds usually have a call protection which prohibits the issuer from calling the bonds for a specific period of time, say 5 years. After 5 years, the entity can exercise its rights to repurchase the bonds from the market. The designated date after the call protection has ended that an issuer can call its bonds is referred to as the first call date.

An entity that is scheduled to call its existing bonds on a specified call date can choose to issue new bonds of which the proceeds will be used to fulfill its interest payments and principal repayments on the existing older bonds. The new bond that will be issued for this purpose is referred to as a pre-refunding bond. Pre-refunding bonds are typically issued by municipalities, and are secured by high credit-quality investments. The new bonds are known as refunding bonds, and their proceeds are used to pay off the older bonds, referred to as refunded bonds. The refunded bonds are paid off at a predetermined date, hence, the term “pre-refunded” bond. Using pre-refunding bonds can be a good method for issuers to refinance their older bonds when interest rates drop.

In anticipation of the future date when the old bonds will be repurchased, the proceeds from the new issues are held in escrow and invested in low yield but high credit quality vehicles, such as cash investments or Treasury securities that mature around the same time as the original bonds. On the first call date or subsequent call dates, the funds held in escrow are used to settle interest and principal obligations to investors of the old bond. The interest accumulated from the Treasury securities pays off the interest from the pre-refunded bond.

For example, suppose that in June 2016, XYZ City decided to call its 9% callable bond (originally set to mature in 2019) for $1,100 on its first call date of January 2017. In July, XYZ City issued a new bond yielding 7% and took all the proceeds from that bond and invested them into T-bills, ensuring that enough money would be available to retire the issue come January.

Like most municipal bonds, interest on pre-refunded bonds is exempt from federal income tax and some state taxes. This tax benefit makes pre-refunded bonds an attractive investment option for investors in the high income tax brackets.