Introduction of Advance Refunding
Advance refunding means a practice wherein funds are received by 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 basically refers to paying the outstanding debt in advance, i.e. prior to their maturity date. The obvious question arises is why would a company pay for its debts beforehand! Well, the reason is the rate of interest.
- The rate of interest or coupon rate is the committed cost of the issuer. This cost is fixed as per contract normally and does not vary according to the 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 to 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 a period of 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 cost, this method is famous in its kind.
Features of Advance Refunding
- The issuer has an existing 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 are reduced.
- This results in the postponement of existing debt with the benefit of a reduction in committed cost.
- The proceeds from the new issue are required to deposit in an escrow account, handled by underwriters to the issue.
How Does It Work?
- It all starts with when the issuer has an outstanding debt with higher interest cost, and the rate of interest in the market has reduced drastically.
- The bond issuer wants to refinance the existing debt with reduced committed cost before the outstanding debt is matured. This helps the issuer to honour its debt obligations before it is due for repayment. This system is used by a local municipality that has unpaid current bonds.
- After issuing new bonds, the proceeds are required to be kept in an escrow account for more than 90 days, wherein the issuer earns interest on the same.
- Post such period, the issuer is allowed to pay off the outstanding debt using the interest earned and the original principal amounts from such treasuries.
Example of Advance Refunding
Lets’ say a municipality wants to refinance its outstanding municipal bonds after it observed the reduction in market interest rate. So as 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 with the responsibility for fund raising. The underwriter also helps in advance refunding. The municipality will invest the proceeds in US treasuries. The underwriter will transfer the funds from the treasuries account to an account called an escrow portfolio. 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, this system is abused many times by the issuers. The reason is a 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 cost with the potential to earn huge income by investment in high-yielding investments.
- Thus, regulations have been imposed so as 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 to use 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 be used to pay off the outstanding debt of taxable bonds. Section 149 of IRS is not applicable in case the taxable bonds are to be refunded.
- Further, the treasury regulations provide a limit on the number of advance refunding. As per the said regulations, taxable advance refunding is not considered as advance refunding. This means it would be treated as a tax-exempt issue.
- A tax-exempt issue can be refunded 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 is considered for section 149. This applies only if both the 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 cost due to a drastic reduction in market interest rate, at which new bonds are issued.
- City municipalities widely use this system.
- It helps to refinance of 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 cost.
- 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 come within the ambit of the IRS.
- The issuer needs to wait for 90 days and need to park the proceeds compulsorily in treasuries.
- For the period of 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 cost using proceeds of new bonds, the issuer is now required to pay tax on such issue. 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 have to face legal repercussions.
This is a guide to Advance Refunding. Here we also discuss the definition and how does advance refunding work? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –