Making Sense Out of Refunding Opportunities

Submitted by: Michael C. Givler, Partner

"Advance refunding" allows the bond issuer to benefit from lower interest rates on callable bonds prior to the call date. Proceeds from the sale of the refunding bonds purchase government securities, which are deposited into an escrow account. The account is structured so the principal and interest on securities are sufficient to pay all principal, interest and call premium, if any, on the called (refunded) bonds through the call date.

When does an advance refunding make sense? The simple answer is when an issuer can realize significant present value savings through advance refunding. This works in today's market, even though the Federal Reserve has increased short-term rates, because long-term rates remain at historically low levels. The amount of savings is affected by the spread between current market rates and rates of the callable bonds, the amount of refunding bonds issued, the amount of bonds outstanding and the time remaining before the bonds are callable.

Under Internal Revenue Code a bond issue may be "advance refunded" only once. The refunding bonds may be refunded later, but under the "current refunding" rules. Factors to consider with advance refunding bonds:

• The refunding bonds are issued "in advance" of the actual call date (closed more than 90 days prior to the call date) and placed in an escrow account pending the call for the refunded maturities. The escrow account earns interest up to the arbitrage rate, which when combined with the refunding net proceeds, pays the debt service principal and interest payments through the call date.
  
• The refunding bonds are secured by the same sources of tax revenues previously pledged to the outstanding bonds.
  
• Arbitrage restrictions often require issuers of advance refunding bonds to purchase State and Local Government Securities (commonly known as "SLUGs") or U.S. Treasury securities to support the escrow.
  
• A refunding of high interest bonds with lower interest bonds must result in a present value savings, determined by the spread between the old and new rates which must be sufficient to offset any redemption premium, cost of issuance and escrow cost.
  
• If the bond issue has not completed its three-year temporary period and construction is not completed, the impact on construction fund interest earnings must be evaluated.

In the next issue of Footnotes, we will explore the points to consider in current refunding and industry standards. Part III will address how to measure savings. If you would like further information, please contact us at footnotes@umbaugh.com.