Pre-Refunding Bond
What Is a Pre-Refunding Bond?
A pre-refunding bond is a debt security that is issued to fund a callable bond. With a pre-refunding bond, the issuer chooses to exercise its right to buy its bonds back before the scheduled maturity date.
The proceeds from the issue of the lower yield or potentially longer maturing pre-refunding bond will as a rule be invested in Treasuries (T-bills) until the scheduled call date of the original bond issue happens.
Pre-Refunding Bonds Explained
An entity that is scheduled to call its existing bonds on a predefined call date can decide to issue new bonds of which the proceeds will be utilized to satisfy its interest payments and principal repayments on the existing more seasoned bonds. The new bond that will be issued for this purpose is alluded to as a pre-refunding bond. Pre-refunding bonds are typically issued by municipalities, and are secured by high credit-quality investments. The new bonds are known as refunding bonds, and their proceeds are utilized to pay off the more established bonds, alluded to as refunded bonds. The refunded bonds are paid off at a predetermined date, thus, the term "pre-refunded" bond. Utilizing pre-refunding bonds can be a decent method for issuers to refinance their more seasoned bonds when interest rates drop.
A callable bond is one that can be "called" or repurchased from the secondary market by the issuer before the maturity date of the bond. At the point when interest rates in the economy drops, bond issuers have an incentive to repurchase existing bonds which have higher fastened interest payments, and issue new bonds at the lower interest rates in the market. This decreases the responsible entity's cost of debt as lower coupon payments to bondholders. In any case, to urge investors to purchase callable bonds, these bonds ordinarily have a call protection which prohibits the issuer from calling the bonds for a specific period of time, say five years. After those five years, the entity can exercise its rights to repurchase the bonds from the market. The designated date after the call protection has ended that an issuer can call its bonds is alluded to as the first call date.
Other Considerations
In anticipation of the future date when the old bonds will be repurchased, the proceeds from the new issues are held in escrow and invested in low yield but high credit quality vehicles, for example, cash investments or Treasury securities that mature around similar time as the original bonds. On the first call date or subsequent call dates, the funds held in escrow are utilized to settle interest and principal obligations to investors of the old bond. The interest accumulated from the Treasury securities pays off the interest from the pre-refunded bond.
Like most municipal bonds, interest on pre-refunded bonds is exempt from federal income tax and some state taxes. This tax benefit makes pre-refunded bonds an attractive investment option for investors in the high-income tax brackets.
Model
For instance, assume that in June 2016, XYZ City chose to call its 9% callable bond (originally set to mature in 2019) for $1,100 on its first call date of January 2017. In July, XYZ City issued another bond yielding 7% and took all the proceeds from that bond and invested them into T-bills, guaranteeing that enough money would be accessible to retire the issue come January.
Highlights
- A pre-refunding bond is issued by a corporation with the purpose of funding a callable bond at a later date.
- In the interim period between the initial issue and the subsequent callable bond issue, proceeds are held in safe Treasury securities.
- Pre-refunding is a strategy utilized by corporations to effectively refinance their outstanding debt.
