Advance Refunding (Definition, Example)

Advance Refunding Definition

Advance refunding is a process in which the proceeds from the bond are used to clear up the dept 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 bonds. In this type of mechanism, the refinancing 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 underwriters 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.

How does it Work?

It is generally associated with the municipal bonds 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 exemption 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 the days near to 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 risk as to 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 bonds 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 in 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. Whereas 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 account whereas this is not a requirement in case of current refunding.
This is done usually 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 intent 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 the 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.