Making Sense Out of Refunding Opportunities

Part III: Measuring Savings

Submitted by: Michael Givler, Principal

Whether you are doing advance or current refunding, exercise caution when refunding bonds. Make your decision based on information and do not be "pushed" into a refunding. Fully explore all aspects to ensure acceptable savings and understand the impact the refunding may have on overall debt structure or any arbitrage impact on the current bonds.

Taxpayer savings should be substantial to justify the refunding. Savings are generally discussed in terms of present value savings and net of the fixed and variable costs of issuance. While market conditions may be right to show a savings, other factors may suggest when or how much should be refunded. For example, a refunding may be blended with new bonds to make the refunding more cost effective. Given the many variations, it is advisable to have a strategic approach.

Considerations that affect refunding opportunities are:

• the difference in interest rate between the refunding and refunded bonds
• escrow interest income rates
• the spread between the refunded bond rates and escrow interest rates (which may be limited by the arbitrage rules)
• the call date for existing bonds
• the cost of issuance

For recently issued bonds, consider the impact on construction fund earnings. A refunding will end the temporary period (generally three years) and may cause a loss of interest earnings retained for use on the construction project.

No laws dictate a minimum standard for savings derived from a refunding, but the industry standard suggests a present value savings of 2% or more. Most securities professionals agree that savings from a refunding are significant if:

1.      Present value savings equal or exceed 3% of the amount of bonds being refunded.

2.      The actual dollars saved impact the issuer's current or future borrowing capabilities or finances (e.g., a tax rate reduction).

Savings should be measured in true dollars as well as future or present value dollars.

For a simplified example, consider an outstanding issue with a $10 million principal and future interest payments totaling $9.5 million. If the issuer had $10 million to redeem all principal today it would not have to pay any future interest. Measured in true dollars, it would appear the issuer saved $9.5 million, but the issuer could invest funds on hand at current taxable rates. It is possible that compounded interest earnings would more than offset the total future interest costs. The present value analysis measures alternative uses for cash. Arbitrage rates and rules related to tax exempt bonds may limit what can be done, but we wanted to keep this example simple.

Remember: "If it sounds too good to be true, it probably is." Implementing a refunding requires complicated mathematical computations and acquisition of securities that meet the IRS Code and SEC Rules. Timing the needs of the district is a critical factor as is having adequate staff time to orchestrate the refunding.

If you have questions regarding refunding, the amount of savings, the impact on the taxpayer or other debt-related issues, please contact us at footnotes@umbaugh.com.