Updated July 14, 2023
Introduction of Advance Refunding
Advance refunding is a practice wherein funds receives by the issuance of lower coupon bonds or lower interest debt, and such funds are held for more than 90 days by the issuer/borrower in an escrow account before paying off the proceeds against old outstanding debt, which results in cost savings in terms of lower finance cost.
- Advance refunding refers to paying the outstanding debt in advance, i.e., before its maturity date. The obvious question is why a company would pay for its debts beforehand! Well, the reason is the rate of interest.
- The issuer commits to the interest or coupon rates, representing their fixed cost. This cost remains unchanged per the contract and does not fluctuate based on market interest rates.
- The issuer is at a loss when the interest rates in the market have gone down drastically, and it is still paying interest at the contracted coupon rate. Here comes the concept of “callable bonds”, wherein the issuer has the right to call for the prepayment before the maturity date. Advance refunding is just a process within callable bonds.
- Under advance refunding, the issuer will issue new bonds to the prospective lenders. After receipt of such funds, they will be kept in an escrow account for more than 90 days. After 90 days have crossed, the funds are released for payment to outstanding debt holders.
- This method is used for the postponement of existing debt. Since the lender are changed with reduced interest costs, this method is famous for its kind.
Features of Advance Refunding
- The issuer has a higher interest cost of debt, and the due date of such bonds is within the next few months.
- The issuer is normally a city municipality.
- The issuer will issue new bonds with a lower interest rate when the market interest rates reduce.
- This results in postponing existing debt with the benefit of reducing committed costs.
- The proceeds from the new issue require a deposit in an escrow account handled by underwriters.
How Does It Work?
- It all starts when the issuer has an outstanding debt with a higher interest cost, and the market interest rate has reduced drastically.
- The bond issuer wants to refinance the existing debt with reduced committed costs before the outstanding debt is matured. This helps the issuer to honor its debt obligations before it is due for repayment. This system uses by a local municipality that has unpaid current bonds.
- After issuing new bonds, the proceeds must be kept in an escrow account for over 90 days, wherein the issuer earns interest.
- Post such a period, the issuer can pay off the outstanding debt using the interest earned and the original principal amounts from such treasuries.
Example of Advance Refunding
After observing the market interest rate reduction, a municipality wants to refinance its outstanding municipal bonds. To issue a new set of bonds, it would take the help of an underwriter. An underwriter is a company or firm within an investment bank that will take care of administrative & compliance issues connected with the new issue. The underwriter is given the responsibility for fundraising. The underwriter also helps in advance refunding. The municipality will invest the proceeds in US treasuries. The underwriter will transfer the funds from the treasury account to an escrow portfolio account. This portfolio will help the issuer to earn income. After a certain period, the underwriter transfers the payment for outstanding debts.
Regulations of Advance Refunding
- Given the benefits associated with advance refunding, issuers often abuse this system. The reason is the lower interest rate of municipal bonds. A lower interest rate means a lower cost of finance for the issuer. Municipalities can easily issue more and more bonds to any extent. This makes the local government over-leveraged at a lower price, with the potential to earn huge income by investing in high-yielding investments.
- Thus, regulations have been imposed to limit such transactions of advance refunding. Post-December 31, 2017, the interest income is removed from the status of tax-exempt provisions.
- The IRS further has provided an upper cap for earnings from an investment in the escrow portfolio. The regulations further restrict the municipalities from using the advance refunding system only for one time in the entire lifetime of the bond issue.
Taxable Advance Refunding
- The treasury regulations provide restrictions to curb the abuse of advance refunding.
- Bond issues can be tax-exempt as well as taxable. This means proceeds from the issue of tax-exempt bonds can use to pay off the outstanding debt of taxable bonds. Section 149 of the IRS does not apply when refunding taxable bonds.
- Further, treasury regulations limit the number of advance refunding. As per the regulations, taxable advance refunding does not consider advance refunding. This means it would treat as a tax-exempt issue.
- A tax-exempt issue can refund from the proceeds of a taxable issue. If the taxable issue is refunded using the proceeds of the tax-exempt issue on the date of maturity, then the taxable advance refunding consider for section 149. This applies only if both issues are outstanding at a time for more than 90 days.
Some of the advantages are given below:
- The foremost advantage is a reduction of finance costs due to a drastic reduction in the market interest rate at which new bonds are issued.
- City municipalities widely use this system.
- It helps to refinance existing debts and results in the postponement of current debt.
- The proceeds from the new issue are paid to wipe off the outstanding debt of high-interest costs.
- It also helps management to restructure the capital funding in the company.
Some of the disadvantages are given below:
- Earlier, it was used to be tax-free. After the amendment in 2017, such issues came within the ambit of the IRS.
- The issuer must wait 90 days and park the proceeds compulsorily in treasuries.
- For 90 days, the issuer is required to pay interest on both issues.
- Hiring cost is involved since underwriters manage the entire process.
- Sometimes the NPV of bond refunding can be negative given the net cost of the issue, in which case it would not be advisable to refund old bonds.
Even if advance refunding is the easiest mechanism for paying off old debts with higher committed costs using proceeds of new bonds, the issuer must now pay tax on such issues. Further, there is a risk of price manipulation in the case of such bonds, which affects the demand for bonds. However, managing the new issue and paying off the old issue requires expertise; else, the issuer may face legal repercussions.
This is a guide to Advance Refunding. Here we also discuss the definition and how does advance refunding works. Along with advantages and disadvantages. You may also have a look at the following articles to learn more –