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Municipal bond refundings may offer safe tax-exempt income.

If you keep cash in a bank account or a money market fund, you're certainly aware of the low interest rates that prevail today. Those rates are having an impact on municipal bond investments, too. Although interest rates are down, lowering yields to investors, so-called municipal bond "refundings" are up. As a result, you may be able to earn relatively high tax-exempt income with little risk of default.

Reduced borrowing costs

Municipal bond issuers can borrow at today's low interest rates. In a refunding, the money from the newly issued municipal bond will enable payment of the debt service on an issuer's older, higher yielding bonds, as explained later. Eventually, old bonds will be redeemed and essentially replaced by newer, lower yielding bonds, which can save money for the state and local government agencies that issue municipal bonds.

Recently, Barron's reported that nearly 60% of the money raised by issuing municipal bonds in 2012 has come from refunding transactions. Earlier in this century, annual refundings have ranged from 31% to 47% of total issuance, so based on that, refundings have surged this year. For example, Bellevue, Washington, has refunded bonds issued for the remodeling of its city hall. That move dropped the average interest rate on such bonds from 5.2% to about 3.5%. City officials in Bellevue said the refunding is expected to save the city more than $9 million over the next 30 years.

Impact on investors

After a municipal bond refunding, the issuer uses the proceeds of the new issue to purchase highly rated collateral, such as U.S. Treasury bonds, and places that collateral into an escrow account. Generally, the bonds purchased as collateral are set to mature at the first "call date" of the original bonds.

Example: A city issued municipal bonds several years ago with a 5% interest rate. The bonds were set to mature in 2024, but the earliest call date was 2014. That is, these bonds can be redeemed prematurely in 2014.

Now that interest rates have fallen, the city issues new bonds with a 3.5% interest rate, which will be less expensive. The money raised from this new issue is used to buy Treasuries that mature in 2014. The Treasuries are placed in an escrow account, securing the interest payments and the redemption of the older bonds.

In this example, the older bonds have been "prerefunded." They won't be redeemed until 2014, but the mechanism for paying the debt service and returning principal to investors already is in place. Consequently, investors who own these bonds typically have little risk of default.

Often, investors who buy prerefunded municipal bonds receive relatively high yields from the date of purchase to the call date. If Treasury notes maturing in 2014 yield 2%, for instance, prerefunded municipal bonds may yield upwards of 3% until the scheduled call in 2014. Moreover, the interest on Treasuries is subject to federal income tax, but municipal bond interest is usually tax-exempt.

Therefore, conservative investors seeking a place to hold cash in the short term may want to consider prerefunded municipal bonds, which are offered by many brokerage firms. Our office can help you determine the tax consequences of specific issues.

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Publication:CPA Client Bulletin
Date:Jun 1, 2012
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