Pre-refunding bonds, also known as advance refunding bonds, offer many advantages to an issuer. They can be used to refinance a bond previously issued at a higher interest rate and lock in the lower rates when markets become more favorable.

But what exactly is a pre-refunding bond? In this blog post, we'll take an in-depth look at the features of pre-refunding bonds and examine how they can provide issuers with significant savings opportunities over time.

We'll explore the different types of pre-refunding and discuss their associated risks, costs, and benefits. Finally, we'll look at some strategies an issuer should consider before deciding whether a pre-refund may be right for them.

Definition

A pre-refunding bond is a municipal bond used to refinance existing debt at more favorable terms. This process, known as advance refunding or "pre-refunding," allows issuers to lock in lower rates when interest rates drop below the rate initially established on the original bonds. Pre-refunds are also referred to as advance refunding bonds or ARBs.

Pre-refunding is most common with long-term debt since it can take up to 10 years before the savings on interest payments outweigh the costs of issuing new bonds. Pre-refunding bonds are not available for all types of existing debt and must meet certain criteria set by the issuer's state, county, or municipality.

Pre-Refunding Bonds Explained

A pre-refunding bond is issued when an issuer wishes to call its existing bond before the maturity date. The issuer will use the proceeds from issuing the new bond to pay off the older one, referred to as a refunded bond.

Since interest rates fluctuate in response to economic conditions, an entity can replace its higher interest-rate bonds with lower ones when rates become more favorable. This "refunding" of the older bond gives pre-refunding bonds their name.

Pre-refunding also typically requires call protection to incentivize investors to invest in these bonds. Call protection prohibits an issuer from calling their bonds until a specified period has elapsed, usually five years after the issue date.

After that, they can exercise their right to repurchase the bonds from the market. This specified date is the first call date, and issuers must know it when planning their refund.

The benefits of using pre-refunding bonds are significant from an economic and financial standpoint. By refinancing their older bonds with newer ones, issuers can lock in lower

interest rates which helps reduce their cost of borrowing over time. These savings can fund other projects or repay debt more quickly.

Additionally, pre-refunding bonds protect rising interest rates since the issuer has already locked in a favorable rate for the new bond's duration.

Pre-refunding bonds are a great way for entities to refinance their existing debt into more favorable terms. They offer significant savings opportunities and protect rising interest rates as long as the issuer accounts for call protection. As such, they should be strongly considered when planning any bond issuance strategy.

Other Considerations

The process of issuing pre-refunding bonds can be a complex undertaking. Several other considerations should be considered when evaluating the viability of this type of bond for an issuer.

Tax Considerations

Certain tax implications may be associated with the transaction when a pre-refunding bond is issued. Depending on the circumstances, it could result in higher taxes due or additional refinancing costs if state and local income taxes apply to the new debt issue.

Additionally, suppose the pre-refunded bonds are not issued within one year from the issuance date of the original bonds. In that case, certain federal income tax rules may limit or eliminate any possible savings from refunding.

Debt Structure

Pre-refunded bonds can be structured in various ways, including fixed and variable rate options. When selecting the right structure for your situation, it's important to consider the type of debt instrument offered and its maturity date.

Choosing the appropriate call features should also be considered to ensure you can capitalize on favorable market trends over time.

Economic Conditions

The current economic conditions will significantly determine if pre-refunding is an option for your organization. If interest rates have increased since the original issuance date of the bond, then it may not be prudent to refinance at this time.

However, if interest rates have decreased, pre-refunding may be viable. The current bond market conditions should also be considered to determine if your organization would benefit from any potential savings realized via pre-refunding.

Credit Rating Impact

Issuing pre-refunding bonds can impact an organization's credit rating positively and negatively. On the one hand, it can signal to the markets that your issuer is financially responsible and committed to managing its debt obligation prudently.

On the other hand, if interest rates rise during the issuance of the new bonds, this could negatively impact your issuer's credit ratings due to the increased debt burden. Therefore, it is important to carefully weigh the potential risks and rewards of issuing pre-refunding bonds concerning your organization's credit rating.

Example

An example of pre-refunding bonds is a local government that issued a bond in 2016 with an interest rate of 5%. The bond is set to mature in 10 years. However, interest rates have dropped significantly since the original issuance date. In this case, the issuer might issue a pre-refunding bond with an interest rate of 3%, which could result in significant savings over time.

The proceeds from issuing the new pre-refunding bond are used to pay off the existing debt and lock in the lower rate for 10 years. This allows the issuer to realize immediate savings on their financing costs while protecting against rising interest rates for at least 10 years until maturity.

Before deciding whether this type of bond is right for your organization, it's important to consider the associated risks, costs, and benefits.

Pre-refunding bonds can provide issuers with significant savings opportunities over time; however, careful planning is required since it can take up to 10 years before the savings on interest payments outweigh the costs of issuing new bonds.

Strategies To Consider Before Opting For

Pre-Refunding Bonds

Before deciding to pre-refund a bond, issuers should consider several strategies which can help maximize savings and minimize risks. These include:

• Evaluating the Bond Market – Pre-refunding only makes sense when market conditions are favorable. Issuers must understand the forces driving interest rates to decide whether pre-refunding suits them.
• Analyzing Cost Savings – Issuers should also carefully analyze the potential cost savings of pre-refunding before making a final decision. This will allow them to determine if the costs associated with executing a pre-refund are worth the long-term benefits they may experience.
• Reviewing Call Provisions – Pre-refunded bonds are often subject to call provisions, limiting an issuer's ability to redeem the bonds early. Issuers need to understand these provisions before entering into a pre-refund agreement.

FAQs

Are pre-refunded bonds safe?

Pre-refunded bonds are considered safe investments, as the issuer must pay back the principal plus interest regardless of market conditions. However, there are risks associated with pre-refunding, which should be carefully assessed before a bond is issued.

What are some advantages of pre-refunding?

The primary advantage of pre-refunding is that it can provide significant savings over time by locking in lower interest rates and protecting against rising interest rates. Additionally, it can reduce an issuer's debt burden more quickly than if no action was taken.

What factors should be considered when evaluating pre-refunding options?

When considering pre-refunding options, issuers should evaluate the current bond market conditions, analyze cost savings potential, review call provisions, and consider any tax implications associated with the transaction. Additionally, economic conditions should be considered to determine whether pre-refunding is viable.

Conclusion

Pre-refunding bonds are a wise way of managing your debt. They allow you to reissue bonds at a lower rate to service current or future debt payments. You will only have to pay off your original bond debt once the new bond comes due, and the lower rate will save you money in the long run. While pre-refunding bonds can benefit certain situations, weighing all other considerations before making any decisions is important.