Definition
Advance refunding is a finance strategy where an entity issues new bonds to pay off existing bonds prior to their maturity date. The primary objective of this strategy is to take advantage of lower interest rates available in the market. It offers the benefit of reducing the apparent cost of the debt, despite the cost of issuing new bonds.
Key Takeaways
- Advance Refunding is a strategy used by bond issuers to save on interest costs by refinancing a bond before its call date. The issuer does this by issuing a new bond at a lower interest rate and using the proceeds to buy a Treasury bond that will cover the old bond’s payments until it can be called.
- An essential element of advanced refunding is the escrow account. The proceeds from the new bond are placed in escrow and used to buy Treasury securities. The Treasury securities generate income that is more than enough to make the interest and principal payments on the original bonds, which remain outstanding.
- There are two types of advance refunding: current and deferred. In a current refunding, the original issue will be retired within 90 days. In a deferred refunding (aka advance refunding), the original issue won’t be retired for at least 90 days. The 2017 Tax Cuts and Jobs Act prohibited the deferred kind for most types of bonds as of January 2018.
Importance
Advance refunding is an important finance term primarily utilized in the realm of municipal bonds. It refers to the process where an entity issues new debt to repay outstanding debt before it matures.
This is particularly important as it allows the issuer to take advantage of lower interest rates, or to remove restrictive covenants imposed by the terms of the original bond. Essentially, it is a strategy used to save money on interest payments over the long term and to increase financial flexibility.
However, timing is crucial in advance refunding as it involves predicting interest rate movements, which entails a certain degree of risk. Therefore, understanding this term is crucial to the strategic management of debt obligations.
Explanation
Advance refunding is a financial strategy primarily used by corporations and government entities to reduce their debt-related liabilities. The purpose of advance refunding is to enable these organisations to reap the benefits of lower interest rates on their existing debts.
This is achieved when the borrower issues new bonds at a lower interest rate and uses the proceeds to repay or redeem an existing higher-interest debt in advance of its maturity date. The new bonds are used as collateral to create an escrow account, the funds from which are used to make the interest payments on the old bonds until they are called or reach their maturity.
Advance refunding is commonly used as a hedging technique against interest rate risk. It effectively allows organizations to lock-in their borrowing costs at a reduced rate, protecting them from potential increases in future interest rates.
It also offers the benefit of improved budget certainty, as organizations can forecast their future debt service costs more accurately. However, it’s important to note that there can be restrictions and potential tax implications involved in advance refunding bonds which should be considered as part of the decision-making process.
Examples of Advance Refunding
Municipal Bonds: Suppose a city issues municipal bonds to fund the construction of a new school. After a few years, if the interest rates in the economy drop significantly, the city might decide to go for advance refunding. They would issue new bonds at a lower interest rate and use the proceeds to buy Treasury bonds that would be put in an escrow account. The Treasury bonds would then pay off the old, higher-interest municipal bonds on their call date, helping the city to save money.
Corporate Bonds: Consider a corporation that had issued bonds to raise capital for the expansion of its business. If interest rates decline, the corporation might opt for advance refunding by issuing new bonds at the lower rates to investors. The proceeds are then placed in an escrow account and used to pay off the old bonds when they reach their call date or maturity.
Housing Authority’s Mortgage-Backed Securities: Suppose a Housing Authority issues mortgage-backed securities with returns based on payments from a group of home loans with high-interest rates. As time goes on and the interest rates drop, the Housing Authority may opt for advance refunding. It issues new mortgage-backed securities at the lower interest rate, and the proceeds from this are put into an escrow account. The funds in the escrow account would be used to pay off the old mortgage-backed securities at their call date. This scenario can provide the Housing Authority with considerable interest expense savings.
FAQs about Advance Refunding
What is Advance Refunding?
Advance Refunding is a strategy where a bond issuer reduces interest rate risk by buying bonds when interest rates have fallen and issuing new bonds at lower rates. The issuer uses the proceeds from the new bond sale to invest, creating enough income to cover the old bond’s obligations.
What are the types of Advance Refunding?
There are two types of advance refunding, current and deferred. In current advance refunding, the old bonds are called within 90 days, while in deferred advance refunding, it takes more than 90 days. The latter is more common because it allows a longer time for the old bonds to be paid off.
What are the potential benefits of Advance Refunding?
Advance Refunding can be beneficial for an issuer who wants to take advantage of lower interest rates to decrease financing costs. It can also be a way for an issuer to remove or alter existing bond covenants. Plus, it can create predictability in debt service payments, which can help with budgeting.
Are there risks associated with Advance Refunding?
Yes, there are risks associated with Advance Refunding. These include reinvestment risk, i.e., risk that the proceeds from the new bond sale may not earn enough to cover the original bond’s debt service. Other risks include legal and regulatory changes that could affect the viability of the transaction.
Are there any restrictions on Advance Refunding?
Yes, under the Tax Cuts and Jobs Act of 2017, governmental and qualified 501(c)(3) bonds cannot advance refund like before. This means that issuers have to consider other alternatives like forward deliveries, rate lock products, or perhaps taxable advance refunding.
Related Entrepreneurship Terms
- Refunding Bonds: Also known as refinancing bonds, these are used to pay off the outstanding principal on older, higher-interest bonds. This is essentially what happens in advance refunding.
- Escrow Account: This is a type of account where funds are held until they can be transferred or withdrawn. In an advance refunding, the issuer might set up an escrow account with proceeds from the new bonds to pay off the old bonds.
- Callable Bonds: These are bonds that the issuer can choose to redeem before they’re due. This feature is important in advance refunding because the issuer might call the bonds if interest rates decrease.
- Defeasance: This refers to the legal process of rendering a bond null and void. In the context of advance refunding, the original bonds are often legally defeased once the new bonds are issued.
- Interest Rate Risk: This is the risk that an investment’s value will change due to a change in interest rates. In advance refunding, the issuer is often trying to lock in a lower interest rate and reduce the risk.
Sources for More Information
- Investopedia: This website provides essential finance- and investment-related information. You can find detailed articles, glossaries, and tutorials.
- MarketWatch: MarketWatch is a comprehensive website where you can find financial news, analysis, and stock market data.
- Bloomberg: Bloomberg delivers business and markets news, data, analysis, and video to the world featuring stories from Businessweek and Bloomberg News.
- MunicipalBonds.com: Since Advance Refunding is often associated with Municipal Bonds, this website provides plentiful data and education specifically targeting municipal bonds.
