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CDFA Spotlight:
What are Advanced Refundings and How Do They Work?
By Stan Provus |
Preface
This article discusses advance refunding of tax-exempt bonds, why they are done, and how these transactions are executed.
Definitions
Current Refunding
Although this article is about advance refundings, it’s important to understand the difference between advance refundings and current refundings. Refunding bonds that are issued to pay off prior (also called “outstanding” or the “refunded bonds”) bonds within 90 days of issuance are called current refundings. Usually, bonds are refunded to take advantage of drops in interest rates, but sometimes, refunding issues are planned ahead of time.
Current Refunding Example
In 2000, the City of Hot Springs needs money to construct a sewer system. The EPA through a State Infrastructure Authority offers a $10 million low interest loan but the City must match this loan with another $10million on its own by the end of the year. The City wants to start work on this project as soon as possible but does not want to issue long-term bonds right now because they believe long rates will drop. As a result, the City issues $10 million Bond Anticipation Notes with a two-year maturity. (Bond Anticipation Notes are generally used as an interim finance vehicle for capital projects and refunded later with long term bonds). Issuing these notes allows Hot Springs to qualify for the State Authority loan, and it now has $20million to begin the project.
Two years later, interest rates have declined to a level where the City fells comfortable issuing long-term bonds. Within 90 days of the redemption date of the notes, Hot Springs issues $10million principal amount of long-term bonds and the proceeds are used to pay off the notes.
This is a current refunding because the proceeds of the bonds (“refunding bonds”) were used to pay-off (“refund”) the notes (“refunded issue”) within 90 days of issuance. There is no limitation on the number of current refundings an issuer can transact.
While current refundings are efficient when interest rates have dropped, they may not always be possible. This is because purchasers of the prior or outstanding bonds may have required call protection when the bonds were sold. Call protection is protection for the bond buyer against having their bonds paid off earlier than their scheduled maturity date. Many long-term bonds (20 plus years) cannot be called for 10 years—that is, they cannot be refunded. This is where Advance Refundings come in.
Advance Refunding
When any of the proceeds of a refunding issue are held longer than 90 days before being used to pay debt service on a prior issue, the issue is an advance refunding issue. Advance refundings permit issuers to lock in lower interest rates or get out from burdensome covenants, while still honoring the call protection on the outstanding bonds. When advance refunding bonds are issued, the prior bonds (refunded bonds) remain outstanding until they are called and replaced by the advance refunding bonds.
Example of An Advance Refunding
This example is taken from the Tax-Exempt Bonds Phase 1 training manual of the Internal Revenue Service, updated on 9/03.
Suppose that City N has $100M of 10% bonds outstanding. These bonds were issued in 1983 and mature in 2003. The bonds are callable in 1995. In 1990, tax-exempt interest rates fall to 7.5% and the city starts to count down the days until the bonds can be called. In January 1993, rates fall to 4%, and the city decides that something has to be done. It does not want to continue to pay interest at 10%, when it can borrow today at only 4%. But according to the terms of the indenture, the bonds can’t be called for another 2 years. The city has paid off $50M in principal, but another $50 million is still outstanding. So the city decides to issue $60M of new bonds at 4% due in 1998. Look at the savings:
| Facts | 1983 Bonds | 1993 Bonds |
| Annual Principal Payment | $5M | $12M |
| Annual Interest Payment | $10M | $2.4M |
| Total Annual Payment | $15M | $14.4M |
In this example, the city saves $600,000 ($15M-$14.4M) each year by issuing new bonds. The prior (original) bonds cannot be called until 1995. Until 1995, the city will have to pay debt service on both bond issues; however, the $ 60M escrow created from the new, advance refunding issue pays debt service on the prior bonds until the escrow is also used to call the 1983 bonds entirely. Meanwhile, the city uses the same revenues it was using to service the 1983 bonds to pay debt service on the 1993 bonds. Because the 1983 bonds have been defeased, the revenue pledge on the 1983 bonds is released. This example is an advance refunding rather than a current refunding because the 1983 refunded bonds can not be called until a date (2 years) that is more than 90 days after the issuance of the 1993 bonds (refunding issue).
Mechanics of an Advance Refunding
Advance refundings are done either to reduce an issuer’s debt service on outstanding bonds—the present value savings should be about 3%. Other refundings are done to remove restrictive bond covenants on outstanding or prior bonds such as rate charge covenants, additional bonds tests or mandatory expenditures. Sometimes a refunding may occur in conjunction with a new money issue. In order to issue the new money portion, the issuer may need to pledge revenues that are currently pledged to the prior (outstanding bonds).
The above example illustrates the basic mechanics of a net advance refunding. With a net refunding in contrast to a gross refunding the proceeds of the bonds and any other available moneys, together with the interest earnings on the refunding bonds and any other moneys are deposited into an escrow account that is sufficient to pay debt service on the refunded bonds.
The escrow account is sized to pay interest and principal on the outstanding (prior or original bonds) bonds as well as any call premium until the earliest date the prior bonds may be called entirely. For accounting and financial reporting purposes the issue (prior bonds) is treated as defeased (and no longer considered debt of the issuer) when the escrow account is comprised of direct obligations or obligations guaranteed by the United States Government irrevocably pledged to the retirement of such debt (i.e. AAA rated securities like Treasuries or SLGs).
Because the arbitrage restrictions on advance refundings are very strict and complex, many issuers elect to purchase SLGs for their escrows. These are United States Treasury – State and Local Government Series (commonly known as "SLGs"), which are purchased directly from the federal government and they avoid any arbitrage problems for issuers. Alternatively, issuers may invest the escrow in portfolio of securities guaranteed by the US government, which if not properly executed may cause arbitrage problems with the IRS.
In a gross or full cash refunding, the proceeds of the refunding bonds alone are sufficient to pay debt service on the refunded bonds—reinvestment income is not taken into consideration to pay debt service on the refunding bonds. Typically, with a gross refunding two series of bonds are issued—the refunding bonds and special obligation bonds, both of which pay debt service on the refunding bonds. However, debt service on the special obligation bonds is paid from investment earnings on the refunding bonds themselves. This structure may result in more bonds being issued than with a net refunding, total annual debt service may be less because debt service on the special obligation bonds is paid from investment earnings on the series of refunding bonds.
Other types of refundings include crossover, high and low, forward, and synthetic refundings. Will explain a couple of these. A high to low refunding is typically done to save interest costs for the issuer. Higher rate outstanding bonds are refunded with lower rate refunding bonds. With a low to high refunding an issuer, for example, may need to defease lower interest rate outstanding bonds so that the revenues pledged to that issue can pay debt service on the refunding bonds, but more importantly, also on a new money issue that is done in conjunction with the refunding bonds. For example, a turnpike authority may issue new bonds to construct toll roads. The new bonds cannot be sold, unless toll revenues on outstanding bonds, which generate a large surplus, secure them. In this situation, a low to high advance refunding (assuming the prior bonds are at a lower rate) is done in conjunction with the new money bonds.
Generally, the Arbitrage regulations permit bonds to be advance refunded only one time. Accordingly, it is imperative that savings are sufficiently high to justify the transaction.
Number of Times a Governmental or 501(c)(3) bond can be Advance Refunded
Private Activity Bonds
IRC section 149(d)(2) prohibits advance refundings for private activity bonds, except for qualified 501(c)(3) bonds. There is, however, no limitation on current refundings of private activity bonds.
Governmental and 501(c)(3) bonds
Section 149(d)(3) limits the number of times governmental and 501(c)(3) bonds may be advance refunded, as indicated in the following table:
Number of Times A Bond Can Be Advanced Refunded
| If the original bond is issued: | Then it can be advance refunded: |
| Before 1986 | Twice |
| Before 1986 and it was already advance refunded two or more times before March 15, 1986 | Once |
| After 1985 | Once |
First Call Date Requirement
Internal Revenue Code Sections 149(d)(3)(A)(ii) and (iii) require that when an advance refunding results in present value savings to the issuer, the prior bonds must be called as indicated below:
First Call Date Requirement
| If the original bond is issued: | Then the original bond must be called (redeemed) from bondholders not later than: |
| Before 1986 | The earliest date on which the bond may be called:
At par, or
At a premium of 3% or less |
| After 1985 | The earliest date on which the bond can be called (regardless of premium amount) |
Conclusion
Advance Refundings are an important financing tool for bond issuers designed to lower debt service on outstanding bonds or remove restrictive covenants. With the exception of 501(c)(3) bonds, private activity bonds cannot be advance refunded, including IDBs, but advance refundings are used extensively for nonprofit and governmental bonds.
Sources: Internal Revenue Service, and Mercantile Capital Markets Group.
This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.
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