Advance Refunding

What Is Advance Refunding?

Advance refunding refers to the withholding of a new bond issue's proceeds for longer than 90 days before using them to pay off (refund) an outstanding bond issue's obligations. The Tax Cuts and Jobs Act (TCJA) repealed the exclusion from gross income for interest on bonds issued to advance refund another bond.

Advance refunding should not be confused with pre-refunding, which involves the issuance of a callable bond.

Understanding Advance Refunding

In corporate finance and capital markets, refunding is the process where a fixed-income issuer retires some of their outstanding callable bonds and replaces them with new bonds, usually at more favorable terms to the issuer as to reduce financing costs. The new bonds are used to create a sinking fund to repay the original bond issues, known as refunded bonds.

Advance refunding refers to the practice of taking the funds received from a new bond issuance to pay off a prior issue's debt. This can only occur after 90 days have passed. The issue of the new bond is, usually, at a lower interest rate than the older, unpaid obligation. Municipalities typically use advance refunding to lower borrowing costs and to take advantage of lower interest rates. 

Advance refunding can also refer to a bond issuance in which new bonds sell at a lower rate than the outstanding ones. The bond issuer places the proceeds from the sale of the newer issue (refunding bond) in an escrow account until they call the older (refunded bond) issue.

Advance refunding is most often used by governments seeking to postpone their debt payments, rather than having to pay off a large amount of debt in the present. In some ways, this is comparable to a homeowner’s mortgage refinance. In 2017, advance refunding bonds totaled $91 billion and comprised 22.2 percent of the $3.8 trillion total municipal bond market.

Regulation of Advance Refunding

Regulators have shown some concern over potential abuses of advance refunding. Since municipal bonds tend to have lower rates, municipalities could potentially use advance refunding to issue unlimited amounts of debt at a low rate. The city could then invest in higher-rated investments. For this reason, regulators have imposed rules that limit the tax-exempt status of the interest on refunding bonds. Furthermore, because of a provision in the Tax Cuts and Jobs Act of 2017, interest income is not tax-exempt for advance refunding bonds issued after Dec. 31, 2017.

Individual states have laws that impose limits on advance refunding, such as statutory maturities and interest rate limits. The IRS restricts the yield earnings on investments from an advance refunding bond issue. Additionally, arbitrage regulations typically permit municipalities to advance refund bonds only one time over the bond’s lifetime. Before initiating advance refunding, cities must first ensure that the amount of money to be saved through the transaction is worth any costs of issuance.

Example of Advance Refunding

Advance refunding is popular in low-interest-rate environments, when bond issuers may seek to take advantage of lower rates by refinancing outstanding bonds that have not yet matured. For example, suppose a municipality wants to refinance its current unpaid bonds at a new, lesser rate. The city would take the proceeds from the sale of the refunding bonds and invest them in U.S. Treasuries or other taxable government securities. The Treasuries are then deposited into an escrow portfolio. The principal and interest earned on the Treasuries in the escrow portfolio are used to pay off the old bonds.