Advance Refunding

What Is Advance Refunding?

Advance refunding alludes to the withholding of a new bond issue's proceeds for longer than 90 days before utilizing them to pay off (refund) an outstanding bond issue's obligations. The Tax Cuts and Jobs Act (TCJA) revoked the exclusion from gross income for interest on bonds issued to advance refund another bond.

Advance refunding ought not be mistaken for pre-refunding, which includes the issuance of a callable bond.

Grasping Advance Refunding

In corporate finance and capital markets, refunding is the cycle where a fixed-income issuer resigns a portion of their outstanding callable bonds and replaces them with new bonds, ordinarily at additional good terms to the issuer as to reduce financing costs. The new bonds are utilized to make a sinking fund to repay the original bond issues, known as refunded bonds.

Advance refunding alludes to the practice of taking the funds received from another bond issuance to pay off a prior issue's debt. This can happen following 90 days have passed. The issue of the new bond is, for the most part, at a lower interest rate than the more established, unpaid obligation. Municipalities typically utilize advance refunding to lower borrowing costs and to exploit lower interest rates.

Advance refunding can likewise allude to a bond issuance where new bonds sell at a lower rate than the outstanding ones. The bond issuer puts the proceeds from the sale of the more current issue (refunding bond) in an escrow account until they call the more established (refunded bond) issue.

Advance refunding is most frequently utilized by governments seeking to defer their debt payments, as opposed to taking care of a large amount of debt in the present. Here and there, this is tantamount to a property holder's mortgage refinance. In 2017, advance refunding bonds totaled $91 billion and contained 22.2 percent of the $3.8 trillion total municipal bond market.

Regulation of Advance Refunding

Regulators have shown some concern over expected maltreatments of advance refunding. Since municipal bonds will generally have lower rates, municipalities might actually utilize advance refunding to issue unlimited amounts of debt at a low rate. The city could then invest in higher-rated investments. Consequently, regulators have imposed rules that limit the tax-exempt status of the interest on refunding bonds. Moreover, in view of a provision in the Tax Cuts and Jobs Act of 2017, interest income isn't tax-exempt for advance refunding bonds issued after Dec. 31, 2017.

Individual states have laws that impose limits on advance refunding, for example, statutory maturities and interest rate limits. The IRS confines the yield earnings on investments from an advance refunding bond issue. Also, arbitrage regulations typically permit municipalities to advance refund bonds just a single time over the bond's lifetime. Before starting advance refunding, urban areas must first guarantee that the amount of money to be saved through the transaction is worth any costs of issuance.

Illustration of Advance Refunding

Advance refunding is famous in low-interest-rate conditions, when bond issuers might try to exploit lower rates by refinancing outstanding bonds that poor person yet matured. For instance, assume a municipality needs to refinance its current unpaid bonds at a new, lesser rate. The city would take the proceeds from the sale of the refunding bonds and invest them in U.S. Treasuries or other taxable government securities. The Treasuries are then saved into an escrow portfolio. The principal and interest earned on the Treasuries in the escrow portfolio are utilized to pay off the old bonds.

Features

• A bond is classified as an advance refunding assuming it is issued over 90 days before the redemption of more established bonds that will be retired utilizing the funds from the new issuance.
• Municipalities typically utilize advance refunding to lower borrowing costs and to exploit lower interest rates.
• Advance refunding is most frequently utilized by governments seeking to defer their debt payments, as opposed to taking care of a large amount of debt when it's due.