Municipal Bonds (Refunding): In our continued effort to educate the investing public about various aspects of the securities markets, we are providing the below information. Because this information is being provided for educational purposes only, it should not be relied upon as providing legal or investment advice. Moreover, it is not intended to be complete in all material respects. If you have any questions concerning the information set forth below, you should contact a qualified professional.
If you are contemplating purchasing a refunding or refinancing municipal bond, you don’t just have to take the word of the retail investment account executive as to what the characteristics of the investment are. You can ask to see a copy of the official statement and any subsequent updates relating to the bond at issue. This will provide you with critical information concerning the proposed investment that should be considered by the potential investor in the privacy of their own home, with any questions concerning the contents of the document addressed to the investment professional.
What Is an Advance Refunding?
A refunding is a refinancing of existing “refunded” bonds with new “refunding” bonds. In general, refundings can be compared to the refinancing of a home mortgage, where a homeowner obtains a new mortgage with a lower rate to pay off an older, more expensive mortgage. Similarly, the issuer of refunding bonds often seeks to lower its interest payments by paying off bonds it has previously issued with newly issued refunding bonds that pay interest at a lower rate than the original refunded bonds. However, in some cases, an issuer may advance refund existing bonds for reasons other than interest cost savings, for example, where an issuer seeks to be released from legal covenants or restrictions made when issuing the original bonds.
An important difference between an “advance” refunding and a typical refinancing of a home mortgage is that, rather than paying off the old debt immediately upon incurring the new debt, the proceeds of the new refunding bonds are placed in an escrow account to be applied according to a predetermined schedule to the future payment of principal and interest on the old refunded bonds. Thus, the refunded bonds are not paid off immediately, but instead will be paid off either as originally scheduled at maturity or on an earlier redemption date in the future according to the bonds’ redemption, or “call,” provisions. The advance refunding of a bond typically will result in a change in the security for repayment of the bond and can also sometimes involve calling the bond prior to maturity. Thus, an advance refunding of your bond can change the timing of your receipt of repayment of your principal on the bond, the credit rating on your bond, and the current value of your bond (either as reflected on your account statement or if you choose to sell your bond).
The refunded bond, which may previously have been secured by a specific revenue source pledged by the issuer to repay the bond – such as a tax levied by the issuer, the revenues generated by a facility financed with bond proceeds, or a variety of other sources – will now be secured exclusively by the escrow account established under the advance refunding document. Often, the legal documents that controlled the security provisions for the bonds will be said to have been “defeased,” meaning that those provisions generally no longer apply to the bonds. Such legal documents typically establish requirements for the quality of investments that must be placed in escrow in order to defease the lien placed on the security for the bonds. It is not unusual for bonds that have been advance refunded to receive a higher credit rating from one or more credit rating agencies due to the establishment of an escrow account holding highly rated investments. This, in turn, can often (but not always) result in a higher market value being placed on the refunded bond than before the refunding.
The advance refunding document sets out important terms of how and when a bond that has been advance refunded ultimately will be paid. The escrow account for the refunded bonds is typically established under the advance refunding document, with the document describing how funds in the escrow account will be invested prior to being used to pay the refunded bonds. Although practices vary, the advance refunding document usually will identify the specific investments being held in escrow. In addition, the advance refunding document generally provides information about whether the advance refunded bond will be paid at maturity or will be called for redemption prior to maturity, including a schedule of payments to be made out of the escrow account corresponding to a schedule of redemptions and maturities. Where less than an entire maturity of a bond is scheduled to be redeemed, the advance refunding document may lay out the process for selecting which bonds of that maturity will be redeemed.
In some cases, bonds may be “escrowed-to-maturity,” which means that moneys held in the escrow account will be used to pay the principal and interest on the bonds as originally scheduled through the final maturity date of the bonds, rather than being redeemed prior to maturity. Thus, the advance refunding does not affect the final maturity date of refunded bonds that are escrowed-to-maturity. An issuer may, however, sometimes reserve the right to call an escrowed-to-maturity bond prior to maturity. For example, an issuer may advance refund a bond that is scheduled to mature on January 1, 2030. Even though the legal documents would allow the issuer to call these bonds for redemption in 2015, the issuer may instead establish an escrow that will continue to pay interest through January 1, 2030 and will pay the principal amount due on January 1, 2030. This bond has been escrowed-to-maturity. However, the issuer may have reserved the right to later exercise the 2015 call provision. If such a right has been reserved, the issuer might subsequently decide to redeem the bonds in 2015, rather than allow the bonds to remain outstanding until maturity.