Pre-Funded Bond

What is Pre-Funded Bond?

Pre-funded bond is a government issued, generally municipal, bond where the funds to pay it off at the call date are set to the side in a escrow account.

Grasping Pre-Funded Bond

Pre-funded bonds are bonds which have their interest and principal obligations guaranteed by risk-free securities in an escrow account. Investors are bound to purchase this bond since there is a dedicated revenue source, practically like a guarantee, currently in place for coupon payments. Pre-funded bonds are issued by municipalities that wish to achieve a higher credit rating for their debt. Since state-issued bonds are not pledged by the full faith of the U.S government, the underlying collateral limits the risk of default.

The pre-funded bond issuer isn't required to generate cash flow to satisfy its payment obligations on the bond as the payment is made through the escrow account. The escrow is collateralized by risk-free Treasury securities, for example, Treasury bills, which generate interest that is utilized to pay the coupons. The pre-funded bond and the U.S. securities will quite often have a similar maturity. The risk-free interest payment permits the responsible entity to set a lower coupon rate on the bond than the rate on a comparable zero-coupon bond. Hence, municipal bond issuers benefit from pre-refunding by decreasing their long-term borrowing costs.

The credit quality of a bond is determined by the level of risk the bond is perceived to have. A lower risk bond will have a higher credit quality and, consequently, a higher credit rating than a higher risk bond. Justifiably, Investors are more drawn to higher rated bonds given that these bonds have a lower risk of default. In this way, to boost lenders to loan money, municipalities issue pre-funded bonds.

The price of pre-funded bonds varies with developments in market rates. The bonds have reinvestment risk yet default-free coupon payments. Pre-funded bonds give the tax benefits present in ordinary municipal bonds, yet are presented to less risks. The federal government-based collateral lessens the potential for the issuer's credit to deteriorate. In any case, pre-funded bonds are generally rated as junk bonds given that they are sold principally by elements that have practically zero cash flow. Assuming the funds in the escrow are tapped out before the bond develops and the issuer needs more cash to get the bond payments, there is a risk that the issuer could default. With the pre-funded structure, a company causes the extra cost of making the escrow fund and the underwriting fees on the escrowed money.

A few pre-funded bonds are defeased securities, that is, at this point not recognized on the issuer's balance sheet. All things considered, the debt obligation is moved from the issuer to the escrow fund. The securities utilized as collateral are adequate to meet all payments of principal and interest on the outstanding bonds as they become due. If for reasons unknown, the funds utilized for defeasance demonstrate inadequate to satisfy the future payment of the outstanding debt, the issuer would keep on being legally committed to make payment on such debt from the pledged revenues. Pre-funded bonds that are defeased will have a provision in the escrow agreement requiring issuer on the pre-funded bonds to make up any shortfall in the escrow account, however this is far-fetched.

Features

• Pre-funded bond is a government issued, typically municipal, bond where the funds to pay it off at the call date are set to the side in an escrow account.
• The pre-funded bond and treasury securities in the escrow account will more often than not have a similar maturity.
• Pre-funded bonds are backed by Treasury securities and issued by municipalities that wish to accomplish a higher credit rating for their debt.