Under the Internal Revenue Code, an advance refunding is a refunding that occurs more than 90 days prior to the date when the outstanding issue is called for redemption. There is no limitation on the number of times that taxable bonds may be issued for an advance refunding. Beware, however, that advance refunding with taxable bonds now may prevent an issuer from realizing much higher savings from a current refunding in the future. For these reasons, an advance refunding should be implemented only when there are significant savings.
This article explores the mechanics of advance refunding with tax-exempt bonds as well as factors that affect the savings.
Advance Refunding Bonds
Advance refunding is a financing technique that allows an issuer to obtain the benefit of lower interest rates when the outstanding bonds are not currently callable. The proceeds from the sale of the refunding bonds are used to purchase taxable government securities, which are deposited in an escrow account. The escrow account is structured so that the principal and interest earned on the securities are sufficient to pay all principal, interest, and call premium, if any, on the outstanding bonds up to and including the call date. The refunding bonds are secured by the same sources of taxes or revenue previously pledged to the payment of the outstanding bonds.
The outstanding debt is generally considered void (defeased) either legally or in substance. A legal defeasance occurs when the covenants relating to the outstanding bonds are satisfied with respect to the retirement of the debt. For accounting and financial reporting purposes the issue is treated as defeased 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.
Federal Tax Law
The mechanics of an advance refunding transaction are governed primarily by the sections of the Internal Revenue Code dealing with "Arbitrage" limitations on tax-exempt bonds. The restrictions on Arbitrage arose from the fact that interest rates on tax-exempt bonds are usually significantly lower than rates available on comparable maturities of taxable securities. Consequently, absent some limitations on the practice, there would be considerable incentive for tax exempt issuers to market a large volume of tax-exempt obligations for the purpose of reinvesting the proceeds in higher yielding taxable obligations in order to realize the spread between the respective rates. This practice, in the judgment of Congress would result in virtually unlimited growth in the supply of municipal bonds, and could adversely affect both treasury receipts and municipal borrowing costs.
In general, the regulations provide that refunding bonds will be treated as arbitrage bonds (interest on the bonds will not be exempt from federal income taxation) if the "yield" on the obligations purchased with bond proceeds exceeds the "yield" on the refunding bonds. Pursuant to the Arbitrage regulations, the term "yield" is used to mean the rate that when used to discount all future payments of principal and interest produces an amount equal to the price paid for the bond issue (excluding any underwriter fees). This method of determining yield is also referred to as the "actuarial" or "Canadian" method.
These restrictions often force issuers of advance refunding bonds to purchase United States Treasury – State and Local Government Series (commonly known as "SLGs") directly from the federal government. SLGs may be purchased at rates below the current market rate in order to adjust yield downward to equal the yield on the refunding bonds. This insures that only the federal government realizes any benefit of a spread between the rates on the refunding bonds and the government securities.
Open market government securities may be acquired in the event that the yield restrictions are not violated. The Code sets forth rules designed to assure that if open market securities are acquired they are purchased at the current market price and not an artificial price designed to comply with yield requirement. A safe harbor rule provides that the market price is established if the issuer receives at least three bids on the securities (the bids may not be from parties that have an interest in the issue such as the financial advisor or underwriter).
State laws and regulations governing refunding bonds should be carefully analyzed prior to structuring a refunding. The following is a brief summary of some of the advance refunding limitations imposed on Illinois and Missouri local governments:
Illinois: Home-rule units of government are exempt from state advance refunding limitations and there are few limitations imposed on utility revenue refunding bonds of non-home-rule units of government. For Alternate Bonds (general obligation bonds secured by a revenue source), the final maturity of the bonds may not be extended and the debt service payable in any year on the refunding bonds may not exceed the debt service payable in any year on the refunded bonds. These limitations also apply to general obligation refunding bonds of governmental units that are in "Tax Capped" counties.
Missouri: Unlike most bonds issued in Missouri, refunding bonds do not require voter approval. Although there are few limitations for refunding revenue bonds (statutory maturities and interest rate limits apply) there are two primary limitations relating to general obligation refunding bonds. First, the rate on the refunding bonds cannot exceed the rate on the bonds being refunded. Second, the principal amount of the refunding issue cannot exceed the principal amount of the bonds being refunded, plus accrued interest to the date of the refunding. The mechanics of advance refunding often result in the cost of the refunding exceeding the amount of bonds outstanding and consequently exceeding the permissible issue size in Missouri. As a result, it is often necessary for Missouri issuers of refunding bonds to make a cash contribution to the transaction or use creative financing approaches.
There are three methods of advance refunding which are the Standard Defeasance (net-cash), Crossover Refunding and Gross Defeasance (full-cash). In a Standard Defeasance (the most common method of refunding), the bond proceeds are used to purchase government securities for the escrow account. When high interest rate bonds are advance refunded with low interest rate bonds, the amount of securities required for the escrow account will be greater than the amount of outstanding bonds being refunded. This is because the portfolio of government securities may have a yield no higher than the rate on the refunding bonds. For example, if the outstanding bonds mature in 10 years at a rate of 6% and the refunding bonds have a 5% yield, then the yield on the government securities may be no higher than 5%. To match the debt service payments of 6% outstanding bonds with 5% government bonds, the difference must be derived through more principal.
As a result, the refunding bond issue must be in a larger principal amount than the outstanding bonds unless a cash contribution is made by the issuer or certain creative financing methods are employed (e.g. high premium bonds). This "upsizing" or "escrow penalty" (as defined by WM Financial Strategies) can eliminate all or a substantial portion of the savings. The refunding will be feasible only if a significant time remains from the date the outstanding bonds were redeemed to the final maturity on the refunding bonds and the spread between the outstanding bonds and refunding bonds is large enough to produce savings sufficiently high to more than offset the escrow penalty.
Negative arbitrage occurs when the yield on the government securities is below the yield on the refunding bonds. When there is negative arbitrage the result is a significantly greater issue size and the feasibility of the advance refunding is often negated.
A refunding of high interest rate bonds with low interest rate bonds may result in a savings if the spread between the rate on the old bonds and the refunding bonds is sufficient to offset any redemption premium, costs of issuance and the Escrow Penalty. As the name "advance" refunding suggests, the bonds need not be currently callable; however, to obtain a savings there must be a redemption of outstanding bonds prior to maturity. If the bonds are callable the issuer realizes the benefit of the spread from the call date to the date of maturity. The new bonds can be structured, however, so that the issuer begins to realize the saving immediately.
In the absence of a redemption provision, an advance refunding would result in a loss at least equal to costs of issuance. Consider a non-callable issue that has an interest rate of 7% to be refunded by 5% bonds. Bond proceeds may be invested at a yield no higher than 5% to pay off the 7% bonds. Because the 5% investments retire 7% bonds, more government securities are required for this purpose than the principal amount of bonds being refunded. Since the cash flow from the escrow must exactly equal the cash flow on outstanding bonds there is a dollar for dollar swap of principal for interest (assuming there is no Negative Arbitrage).
It is sometimes necessary to refund low interest rate bonds with bonds having higher rates in order to modify the debt structure or bond covenants. Although the benefits of a debt restructuring may be significant, this form of refunding cannot result in savings. This is due to the Arbitrage restrictions on refundings. Consider an issue which has an interest rate of 4% to be refunded by 5% bonds. Bond proceeds may be invested at a yield no higher than 5% to pay off the 4% bonds. Because the 5% escrow investments retire 4% bonds, the principal amount of government securities required for this purpose is less than the principal amount of bonds being refunded. The lower principal amount is offset by the payment of higher interest. This trade off of principal for interest results in a break-even transaction (other than with respect for costs of issuance, which would result in a loss).
Generally, the Arbitrage regulations permit bonds to be advance refunded by tax-exempt bonds only one time. Accordingly, it is imperative that savings are sufficiently high to justify the transaction.
It is sometimes difficult to measure whether the savings justify implementing a refunding. Savings should be measured in terms of true dollars as well as in future or present value dollars. The Internal Revenue Code of 1986 recognizes only present value dollars. Likewise the securities industry standard is based on present value dollars. This is because present value dollars are not as easily distorted as actual dollars. For example, consider an outstanding issue in the principal amount of $10,000,000 with future interest payments totaling an additional $9,500,000. Assuming the issuer had $10,000,000 to redeem all principal today it would not have to pay any future interest. Measured in true dollars, it would appear as if the issuer saved $9,500,000. However, this is a distortion. As an alternative to redeeming bonds, the issuer could invest funds on hand at current taxable rates. Compounded, it is possible that the interest earnings would more than offset the total future interest costs on the bonds.
Present value analysis measures alternative uses for cash. By applying different interest rates, it is possible to measure what a dollar today will be worth in the future (future value) or what a dollar obtained in the future is worth today (present value).
Significant Savings Analysis
The amount of savings that should be derived from a refunding is debatable. However, most securities professionals would concur that savings from a refunding are significant if the refunding results in one of the following:
Present value savings equal or exceed 3% of the amount of bonds being refunded. (Since the savings are spread over the life of the issue, present value analysis provides a method of computing the savings as if they were realized today.)
The actual dollar savings are large enough to impact the issuer's current or future borrowing capabilities or finances (e.g. a tax rate reduction).
Implementation of a refunding requires complicated mathematical computations and acquisition of securities that are designed to meet the rules of Code. Timing is critical in order to achieve savings. Bond Counsel and WM Financial Strategies work to insure that the issue complies with all State and Federal rules and regulations and that substantial savings are realized.