Advance Refunding

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.

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.

• 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, refinancing is also done, which helps the municipalities to clear their outstanding debts using advance refunding bonds.
• 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 is generally associated with municipal bonds that are usually of low-interest rates. In advance, refunding bonds and the proceeds from the new bonds are used to pay off all the government's outstanding debtsgovernment's outstanding debts of the government.
• This is necessary to do when the obligor 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 risk as the other bonds in the Agency securities, and in this way, the process of advance refunding will be done.

The advance refunding bonds were exempted from tax payment, which allowed the states greater flexibility to refinance their debts that were already existing. This reduced the cost of borrowing to a large extent.  

In the latest report in finance, the TCJA (Tax Cut and Job Act) 2017 has eliminated the tax-exempt facility for such refunding mechanism for municipal bonds.

Thus, as a result, the tax-exempt advance refunding bonds, which were till then used as a tool for saving costs for the local government and the state, lost their importance as a refinancing option for debt. Due to this, the governments started paying more interest to the residents.

However, in 2023, the legislation for tax exempt advance refunding bonds were reintroduced once again that ultimately save a lot of funds of both the country and its taxpayers. The counties highly support this status of tax-exemption of these bonds.

Such bonds are mainly issued by the local and state governments in order to finance the infrastructure and capital needs such as construction and improvement of roads, transport, schools, hospitals, bridges and other public works. It helps in freeing up resources which can be channelized for more important uses.

Let us try to understand the concept with the help of some examples.

• 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 started to fall and reached 5%.
• In the year 2017 December, the bond’s interest drastically came 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.

Thus, the above examples clarify the various instances where the advance refunding legislation can be used and also its consequences.

Advance refunding legislation is a very nice mechanism for municipal bonds or government bonds, but it has its own limitations 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. However the concept has some benefits which are as follows:

• 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 municipality.
• 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 personnel 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.

It is also necessary to understand the limitations of the concept so that it can be used in the best way possible in appropriate situations.

• 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 should be done correctly. It may attract some legal consequences because the price manipulation of the bonds can also be there to make it saleable.
• 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 significantly less issuance of the bonds in the market because it may hurt the sentiments of the bondholders who were getting higher interest earlier.

The above are two concepts that are in use in the financial market. However, there are some points of differences between them. Let us identify and understand the differences.

• 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 it, 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 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.