Advance Refunding Definition
Advance refunding is a process in which the proceeds from the bond are used to clear up the debt associated with another bond. Here, the new bonds are issued at a lower price, and this mechanism is used to get rid of the higher interest cost by investing in new bonds whose interest cost is less as compared to the old bond.
Explanation
- Advance refunding is used by the government when they are interested in delaying the debt clearances. They adopt this practice to save the interest cost associated with the bonds. The new bonds are then used to pay off the debts associated with the old bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more. In this type of mechanism, refinancingRefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure.read more is also done, which helps the municipalities to clear their outstanding debts.
- The underwriters are appointed to complete the entire process. This process usually takes place when the interest rate is lower. Sometimes it has been seen that the underwritersUnderwritersThe underwriters take the financial risk of their client in return of a financial fee. Market Makers like financial institution and large banks ensure that there is enough amount of liquidity in the market by ensuring that enough trading volume is there.read more can sell or purchase the bonds on behalf of the municipalities. It should be done in a proper manner. It may attract some legal consequences because the price manipulation of the bonds can also be there to make it saleable.
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Source: Advance Refunding (wallstreetmojo.com)
How does it Work?
- It is generally associated with municipal bondsMunicipal BondsA municipal bond is a debt security issued by a national, state, or local authority to finance capital expenditures on public projects related to the development and maintenance of infrastructures such as roads, railways, schools, hospitals, and airports.read more that are usually of low-interest rates. In advance, refunding the proceeds from the new bonds are used to pay off all the outstanding debts of the government. In the latest report in finance, the TCJA (Tax Cut and Job Act) 2017 has eliminated the tax-exemptTax-exemptTax-exempt refers to excluding an individual's or corporation's income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only.read more facility for such refunding mechanism for municipal bonds.
- This is necessary to do when the obligator borrows some money from the market. This is usually witnessed in the days near the maturity of the bonds. The proceeds from the new bonds are then set aside in an escrow account whose credit quality is usually high. Now, after this, the municipal bonds will have the same credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more as the other bonds in the Agency securities, and in this way, the process of advance refunding will be done.
Examples of Advance Refunding
- A bond in a city is having $500 million of 10% bonds outstanding in the market. The bonds were issued in the year 2000 and will mature in the year 2020. These are callable bondsCallable BondsA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond's maturity. This right is exercised when the market interest rate falls.read more and can be called by 2018. In the year 2015, the interest rate in the market of the bond stared to fall and reached 5%.
- In the year 2017 December, the bond’s interest drastically comes down to 2%, and now the municipality is a little worried. They know that they can get this bond at a 2% interest rate, whereas they are paying 10% on the same bonds, so now they decide to refinance the entire outstanding bonds.
- They came to know that they have paid $220 million principal, and the rest amount is outstanding. After consulting, they decided to issue $300 million of new bonds and will use the entire proceeds from that issuance to clear up the old bonds outstanding. This method is known as advance refunding.
Difference Between Advance Refunding and Current Refunding
- This is said to be applied when the sale proceeds of the refunding issue are held for more than 90 days’ time. At the same time, the current refunding is said to be applied when the bonds are issued within 90 days of the issuance.
- In advance, refunding the issuer is required to set aside the sale proceeds from the issuance of the new bonds in an escrow accountAn Escrow AccountThe escrow account is a temporary account held by a third party on behalf of two parties in a transaction. It reduces the risk of failing to oblige the transaction by either of the parties. It operates until a transaction is completed and all the conditions are met.read more, whereas this is not a requirement in the case of current refunding.
- This is usually done by taking care of all the criteria related to the outstanding balances of the bonds, whereas in current refunding, this is not usually taken care of. In current refunding, the municipality intends to clear the ongoing debts.
Benefits
- Municipalities can take advantage of the lower interest rate of the market.
- It helps to refinance the management of the entire bond.
- Bond management can be easily done at a smooth pace.
- It helps to make a plan for the structuring of the bonds in the municipal.
- It helps to reduce the interest cost.
- By using this process, the proceeds of the bonds can be used to eliminate the outstanding debts from the old bonds.
- By advance refunding, the municipal personal can issue the bonds with the lower interest rate in the market, but the issue value can be higher, and then the proceeds are used to clear the outstanding value.
Limitations
- This is no longer tax-free.
- The risk associated is high when the government bonds are converted to Agency securities, and their credit rating is higher after that.
- The underwriters are hired to complete the entire process.
- This can also be illegal when it comes to price manipulation.
- It is said to be applied after the 90 days’ time has expired. The government should call for earlier dates to declare the advance refunding mechanism for better planning.
- The advance refunding mechanism can sometimes be a reason for the significant less issuance of the bonds in the market because it may hurt the sentiments of the bondholders who were getting higher interest earlier.
Conclusion
- Advance refunding is although a very nice mechanism for the municipal bonds or government bonds, but it has its own limitation as well. The bondholders can get demotivated by investing in government bonds. The price of these bonds can be manipulated to either control the supply or to increase the investment in the non-government bonds whose returns and risks both are high.
- This should be done very carefully by hiring experts because it may attract some legal consequences in the future. This mechanism is very helpful for the issuer of the bonds because they can call for the issuance of the new bonds with lower interest in the market.
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