Understanding current and advance refundings.
With interest rates in the municipal bond market approaching the low point in recent history, many government finance officers are being bombarded with proposals to refund their outstanding bonds. Unfortunately, refundings are not widely understood, although they are widely utilized.
This article discusses current and advance refundings and explains the mechanics of refundings. The article also focuses on the three components of an advance refunding transaction; the refunded bonds, the escrow account and the refunding bonds.
In a refunding issue, the proceeds of a refunding (new) issue are used to retire a refunded (old) issue. A refunding issue is usually done to restructure debt, to revise covenants, to realize savings or to achieve several of these objectives. Savings result when the debt service on the refunding issue is lower than the debt service on the refunded issue.
On refundings motivated by debt restructuring, most financial advisors recommend a refunding when it will avoid a default or preclude an unmanageable tax or rate increase. On refundings motivated by covenant revision, most financial advisors recommend a refunding when it will eliminate bond covenants which impede the issuer's ability to construct facilities or provide services.
Due to escrow considerations and issuance costs, the refunding issue will typically have a larger principal amount than the refunded issue, which produces a loss from an accounting standpoint, even if the transaction produces savings from an economic standpoint.
A current refunding occurs when the (old) refunded issue is retired within 90 days after the refunding (new) issue is sold. Proceeds of the refunding issue are used to purchase the refunded bonds from investors at the maturity date or at a call date prior to the maturity date.
A current refunding is less complicated and less costly than an advance refunding, since a current refunding does not require that the issuer establish an escrow account, hire a paying agent/registrar to administer the escrow account, obtain bond ratings on the refunded issue or verify the cash flow in the escrow account.
Most financial advisors will recommend that an issuer pursue a current refunding whenever it produces savings, since the only costs consist of the nuisance cost in the differences between the old tax law and the new tax law and the opportunity cost in the differences between the old call flexibility and the new call protection.
An advance refunding occurs when the refunded bonds are retired more than 90 days after the refunding bonds are sold. Proceeds of the refunding issue are used to buy U.S. government securities, which are held in an escrow account until funds are needed to pay interest on the refunded bonds and to purchase the refunded bonds from investors at the maturity date or at a call date prior to the maturity date.
Prior to the 1986 tax reform act, an issuer could realize savings by refunding old "low coupon" bonds with new "high coupon" bonds. In a "low to high" advance refunding, the "minor portion," which could equal up to 15 percent of the original refunded issue, could be invested in the escrow account at an unrestricted yield. Also, the refunded issue could be escrowed to the maturity date, rather than to the call date, which maximized this legal "arbitrage."
After 1986, an issuer can only realize savings by refunding old "high coupon" bonds with new low coupon" bonds. In a "high to low" advance refunding, the refunded issue is escrowed to the call date, rather than to the maturity date. Because the escrow account can only earn the low refunding bond rate, but must pay the high refunded bond rate, the escrow account requires more funds, resulting in a higher issue size, further resulting in a lower savings level.
Since the Tax Reform Act of 1986 imposed severe restrictions on advance refundings, there is an opportunity cost associated with these financings. The act imposed restrictions on interest earnings, limited the number of times that an issue can be advance refunded, prescribed rules for calling bonds prior to maturity, prohibited issuers from advance refunding private activity bonds, and stiffened the transferred proceeds penalty (described later in this article).
The act permits bonds issued after 1985 to be advance refunded only once. Also, the act requires that bonds called in an advance refunding which produces savings be called at the first date on which they can be redeemed at a call premium of 3 percent or less. Further, the act specifically prohibits several types of "abusive" transactions.
Refunding savings are sensitive both to changes in the level of interest rates and to changes in the shape of the yield curve, which depicts the difference between short-term rates and long-term rates. In most cases, an economical refunding will require at least a 200 basis point (2.00 percent) difference between the old bond rates and the new bond rates, on a maturity-by-maturity basis.
Generally, the savings in a "high to low" refunding solely result when the issuer "saves" the interest between the call date and the maturity date. Most financial advisors will recommend that an issuer pursue an advance refunding whenever it produces savings above a predetermined threshold, such as present value savings equal to 4 percent or 5 percent of the par amount of the refunded bonds, because of the issuance cost and opportunity cost associated with an advance refunding.
Most refunding analyses present the refunded debt service to maturity (which is used for comparison purposes to illustrate savings), the refunded debt service to call (which is used to illustrate the escrow account requirements), the escrow account investments and the escrow account yield (which is used to illustrate the yield restriction), the sources and uses of funds (which is used to illustrate the refunding issue sizing), and the refunding debt service.
The opportunity to realize savings through an advance refunding is determined by the interest rate on the refunded bonds, the interest rate on the escrow account and the interest rate on the refunding bonds.
The opportunity to realize savings through an advance refunding is determined by the nature, size and structure of the refunded bond issue.
The call feature can increase the likelihood of an economical advance refunding. Because the earnings rate cannot exceed the borrowing rate on the refunding issue, it is only economical to refund bonds that can be called. If the call date is many years earlier than the maturity date, an advance refunding will produce more savings.
The issue size also can increase the likelihood of an economical advance refunding. Because many of the issuance costs associated with a bond issue are not directly related to the size of the issue, an advance refunding of a large bond issue will produce relatively more savings than an advance refunding of a small bond issue.
The issue purpose also can increase the likelihood of an economical advance refunding. Generally, an advance refunding of a prior "new money" issue will produce more savings than an advance refunding of a prior advance refunding issue, since the latter must reflect the "transferred proceeds" penalty.
The transferred proceeds penalty is designed to prevent issuers from issuing "high coupon" first refunding bonds and capitalizing the escrow at the high rate, then issuing "low coupon" second refunding bonds and recapitalizing the escrow at the low rate. The present value difference between the escrow cash flow discounted at the high first refunding rate and at the low second refunding rate is subtracted from the target figure in the escrow internal rate of return (IRR) calculation, artificially increasing the escrow yield and decreasing the savings on a dollar-for-dollar basis.
Finally, the maturity schedule can increase the likelihood of an economical advance refunding. Because savings are realized when bonds are called in advance of maturity, an advance refunding of an issue with a long maturity will produce more savings than an advance refunding of an issue with a short maturity.
Savings also are determined by the particular issues and maturities that are being refunded. Generally, by adding or deleting issues and/or maturities, an issuer can create a larger, but less efficient, financing or a smaller, but more efficient, financing.
Escrow Account. The opportunity to realize savings through an advance refunding also is determined by the escrow account.
The yield on the escrow account cannot be greater than the yield on the refunding bonds. Changes in the spreads between the government and municipal markets and the slopes of the two yield curves can create refunding opportunities. Generally, a narrow spread between the government and municipal markets, a flat government yield curve, and an upward-sloping municipal yield curve offer the most attractive conditions for an economical refunding.
"Arbitrage" refers to a price discrepancy between markets. In an escrow account, positive arbitrage exists when the escrow yield is greater than the bond yield, requiring the issuer to suppress the escrow yields by buying lower-yielding escrow securities. Likewise, negative arbitrage exists when the escrow yield is less than the bond yield, encouraging the issuer to stretch the escrow yield by buying higher-yielding escrow securities.
An escrow account also can experience inefficiency. In the ideal situation, an issuer will purchase escrow securities that mature and/or pay interest on the same dates as the refunded bonds mature and/or pay interest. When this is not possible, the escrow receipts which are uninvested between the escrow payment dates and the refunded bond payment dates create the inefficiency.
State and Local Government Series (SLGS) securities are U.S. government securities which are available in amounts, dates and rates to accommodate the yield restriction that might be required and to eliminate any inefficiency in municipal bond escrow accounts. The government publishes maximum SLGS rates each day and permits the issuer to subscribe for SLGS for the amounts and maturity dates required at a rate up to the maximum rate.
Because of the economy and flexibility that SLGS offer, SLGS are typically the preferred escrow investment strategy in instances where the SLGS rates will permit the escrow to be invested at a rate equal to the bond yield.
Otherwise, an issuer may purchase U.S. government securities in the open market. However, even if open market rates are higher than SLGS rates, it may not be possible to purchase open market securities in the amounts, dates and rates required without creating inefficiency in the escrow account. Further, some underwriters have made substantial amounts of money from the brokerage fees associated with open market purchases in the escrow account.
Refunding Bonds. Advance refunding bonds often are sold through a negotiated sale, because of the complexities of the transaction. In an advance refunding, the refunding bond maturities will impact the refunding bond rate, which will impact the escrow account rate, which will impact the amount that must be placed in the escrow account, which will impact the original refunding bond maturities.
Because advance refunding bonds often are sold at negotiated sale, the issue may contain term bonds, as well as serial bonds, particularly with a relatively flat municipal yield curve. A serial bond issue has several stated maturities, whereas a term bond issue has a single stated maturity. The latter may be sold with mandatory sinking fund provisions, whereby a specified amount of term bonds are "called" according to a specified schedule.
The refunding debt service often can be structured in different ways to produce front-end savings, level savings or structured savings. Most financial advisors consider the present value of savings, discounted at the refunding bond rate, recognizing that a dollar in the present is worth more than a dollar in the future. Present value savings will not vary much with differences in savings patterns, but gross savings will be lower for a front-end savings pattern and higher for a back-end savings pattern.
Often, it is necessary to sell refunding bonds with premiums. In Texas for example, issuers such as counties, independent school districts and municipal utility districts have a constitutional requirement that the refunding bonds' par amount not exceed the refunded bonds' par amount. In these situations, the issuer typically derives some proceeds from premiums paid, rather than principal.
For example, if the yield on a 10-year "Aaa" insured bond is 6.00 percent, the bonds can be sold with an above-market coupon of 6.50 percent for an above-par price of 103.79, producing a market yield of 6.00 percent. The amount of the price which is above par (103.79 minus 100.00) is the premium, which equals $37,900 on a $1 million bond in this example.
Because many investors, particularly individual investors, prefer not to pay a price above par, premium often is generated with capital appreciation bonds (CABs), rather than current coupon bonds. When the premium is generated with CABs, the investor does not have to pay a price above par, because the premium is generated by the "nominal" yield on the bonds.
CABs, also known as compound interest bonds or zero-coupon bonds, sell at a discounted value and mature at face value, providing a market yield. The bonds do not pay periodic interest, although the accretion, which is the difference between the initial value and the maturing value, can be considered either accreted principal or compounded interest.
For example, if the yield on a 10-year "Aaa" rated CAB is 6.50 percent, the bonds can be sold with a coupon of 0.00 percent, an above-market (nominal) yield of 7.27 percent for a nominal price of 48.951, and a market (actual) yield of 6.50 percent for an actual price of 52.747. The amount of the price at the actual yield which is above the price at the nominal yield (52.747 minus 48.951) is the premium, which is $37,960 on a $1 million bond in this example.
As it is often necessary to sell refunding bonds with premiums, it often is desirable to sell refunding bonds with discounts. An underwriters discount is one type of discount, whereby the underwriter's profit or spread is deducted from the principal, rather than generated in a premium. Because many investors prefer not to pay a price above par, underwriters may prefer to be paid from the principal.
An original issue discount (OID) is another type of discount, which can offer tax advantages to the investor, yield advantages to the issuer and market protection to the underwriter. When a bond is originally issued at a price below par, the difference between the price and the par value is the OID. The capital gain arising from an OID is not taxable, whereas the capital gain arising from a market discount is taxable, even if the gain is associated with a tax-exempt bond.
OID can produce lower yields for the issuer. On the other hand, because the discount is typically financed in the refunding issue, OID can also produce higher debt service for the issuer. Most financial advisors will scrutinize the structure of an advance refunding, to ensure that any discounts or premiums are properly applied.
The municipal market continues to develop derivative products and innovative techniques to accommodate the constraints of the tax reform act. In the area of advance refundings, several ideas have been successfully tested, including delayed settlements (where settlement on a fixed rate refunding issue is delayed to facilitate a current refunding), forward swaps (where a future variable rate current refunding issue is combined with a forward interest rate swap) and tender offers (where a current refunding issue is undertaken with bondholder consent).
Given current market conditions and recent industry developments, it is increasingly important for government officials to understand current and advance refundings. A basic knowledge of the mechanics of refundings will enable a finance officer to ensure that refunding transactions are undertaken at the lowest possible interest cost and issuance cost, maximizing the associated benefits to the community and its citizens.
Larry Jordan is vice president, First Southwest Company, an investment banking firm located in Dallas, Texas. This article was published in the January 1992 issue of the Newsletter of the Government Finance Officers Association of Texas.
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|Publication:||Government Finance Review|
|Date:||Apr 1, 1992|
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