Bond refundings are most commonly used by state and local governments to achieve savings on interest costs. Refunding bonds can also be issued to remove or revise burdensome bond covenants or to restructure debt service payments, although these are less frequent.
Refunding bonds are characterized as either current refundings or advance refundings. A current refunding is one in which the outstanding (refunded) bonds are redeemed within 90 days from the date the refunding bonds are issued. In an advance refunding, the refunded bonds remain outstanding for a period of more than 90 days from the date the refunding bonds are issued. Under federal tax law, governments may engage in a tax-exempt advance refunding only once over the life of the bonds. Issuers of taxable or tax credit bonds may be subject to different restrictions or tax law. However, the methodology and policies for determining when a refunding might be appropriate may be applied to all types of bonds.
Governments should familiarize themselves with the terminology and market for bond refundings, using the resources section of this best practice, including supplementary material Refunding Bonds Terminology.
The Government Finance Officers Association (GFOA) recommends that issuers include guidelines in their debt management policies that address preservation of future refunding flexibility when issuing any debt, formal refunding objectives, and monitoring of refunding opportunities on outstanding debt.
GFOA also recommends that when evaluating a refunding transaction, issuers should analyze their refunding objectives, the efficiency of any related escrow, and the unique aspects of executing the refunding transaction.
Additionally, as is stated in other GFOA best practices, governments that don’t have dedicated debt management staff, expertise in analyzing refunding opportunities, or access to current bond market data should engage the services of a municipal advisor. Many unique refunding structures are presented to issuers, and these should be thoroughly reviewed with a municipal advisor.
Analyzing Refunding Bonds
Preserve Future Refunding Opportunities. Governments should be attentive to providing for future refunding options when issuing new money and refunding bonds. Two key bond structuring elements are critical in preserving and enhancing future refunding opportunities:
- The optional redemption provision (call date and price).
- The coupon (not the yield) of each bond maturity after the call date.
The typical optional call on a tax exempt bond is generally no longer than 10 years from the date of issuance, and GFOA recommends that bonds do not have a call date later than 10 years. Earlier call dates may be available, but they likely result in somewhat higher yields at the time of issuance, depending on the market. The benefits of an earlier call feature should be weighed against the likely additional costs, and GFOA recommends that issuers request an analysis of the benefits of any alternative call structures. For taxable bonds, the call structures can vary and the cost of different call provisions should be evaluated.
Future refunding opportunities also depend on the coupons – not the yields – on the bonds to be refunded. Bonds with relatively high coupons (e.g. 5%) are more likely to be refunded than bonds with lower coupons. Issuers should consult with a municipal advisor or others in their finance team to determine market preferences at the time of issuance and whether a higher or lower coupon (premium or discount bonds) provide the best economic conditions for the issuer.
Monitor Refunding Opportunities. Issuers should establish a process to identify and monitor potential refunding opportunities in the outstanding debt portfolio as interest rates change. Spreadsheet-based debt tracking, combined with an analysis of current interest rates, can provide “snapshot” looks at refunding opportunities that can then be more rigorously analyzed by the municipal advisor. This tracking should include some or all of the refunding objectives guidelines that are included in issuers’ debt policies.
Establish Guidelines about Refunding Objectives. Issuers shoulddevelop decision guidelines to determine when to refund outstanding bonds. As noted above, tax-exempt bonds can only be advance refunded once under current tax law. Therefore, issuers should develop policies to use this one-time option as efficiently as possible. Guidelines may include some or all of the following, and should be discussed with the municipal advisor:
- Net present value savings – Minimum net present value (NPV) savings are typically measured in relation to the par amount of the refunded bonds. The minimum savings threshold can be a fixed percent, such as 3% or 5%, and/or a minimum dollar threshold. Alternatively, some issuers use a grid of savings requiring higher savings for refundings with longer periods to the call date and higher savings for refundings with longer periods from the call date to maturity. Policies should consider whether refunding thresholds will be applied to an entire issue or on a maturity-by-maturity basis. Current refundings may warrant lower savings thresholds than are set for advance refundings.
- Negative arbitrage efficiency – In a proposed advance refunding, negative arbitrage is how much of potential debt service savings are lost in funding the escrow to the call date. Issuers may want to set a guideline that negative arbitrage is less than a certain percentage of present value savings before a refunding is undertaken.
- Rate efficiency/sensitivity analysis – Issuers should conduct or receive an analysis of how much interest rates would have to rise by the call date to produce savings matching those that could be achieved with an advance refunding. This could result in simply waiting until the call date to refund the bonds.
- Refunding efficiency – Issuers should understand that the call feature included in most municipal bonds has economic value, and they may want to set a minimum of how much of the potential value of the call option should be captured with an advance refunding. These estimates of the value of the call option depend on complex calculations that should be requested from a municipal advisor.
Establish Guidelines on Savings Structure. One of the issuer’s most important decisions is how to “realize” the available debt service savings over the life of the refunded bonds. The most common, known as “uniform savings,” realizes savings in approximately equal annual amounts over the life of the refunded bonds. Alternatively, at times an issuer might wish to “accelerate” the available savings to provide greater near-term debt service relief. When savings are accelerated, or front-loaded, care should be taken to ensure that the debt service on later maturities is no greater than that of the refunded bonds. The municipal advisor can also model other savings structures, tailored to the issuer’s financial needs and any state or local requirements. An analysis of the pros and cons of the structure selected for the life of the financing should be communicated to all stakeholders and should identify any out-years in which debt service increases beyond reasonable revenue growth assumptions, and how these would be funded.
Efficiency of the Refunding Escrow. Proceeds of advance refunding bonds are almost always placed in an escrow account held by a third-party escrow agent. These funds are held until the call date of the refunded bonds and are typically invested so the earnings minimize the cost of the escrow. The most common investments for tax-exempt refunding bond escrow accounts are federally issued SLGS (state and local government securities) and open market Treasury investments (T-bills, notes, and bonds). On occasion, the Treasury SLGS window has been closed to issuers due to Federal budgetary inaction, and escrows are either funded by cash or bond proceeds or funded with the purchase of eligible open market investments. However, if issuers are able to realize the arbitrage yield, and SLGS are available, SLGS should be used due to the ease and reliability of execution. Issuers should review these alternatives with their municipal advisor and should consider the cost of acquiring the investments, the yields, and the matching of timing of investment cash flows with debt service payments.
Address Purpose of Refunding. Debt policies should also address when an issuer will consider a refunding whose primary purpose is not debt service savings. Issuers will sometimes pursue refundings to eliminate restrictive bond/legal covenants, restructure the stream of debt service payments, or achieve other policy objectives. In such cases GFOA recommends that the policy objectives and benefits, along with any economic loss of the refunding, should be clearly understood and articulated to all stakeholders, as well as how such a decision fits into a long-term financial plan.
Executing the Refunding Bond Issue
At the outset of any financing, GFOA recommends that issuers solicit the advice of their municipal advisor and bond counsel to identify key legal and financial issues early in the financing process. Refunding bonds may have special considerations such as call/defeasance notices or escrow accounts, in addition to those associated with other types of financings. Issuers should be aware of these issues, which should be fully discussed with the municipal advisor and bond counsel. Ultimately, the issuer should fully understand these issues before proceeding with the financing.
Refunding Bond Financing Team. In addition to the usual outside financing team members, refunding bonds typically involve specific services related to the refunding transaction. Corresponding to other GFOA best practices on hiring outside bond professionals, securing refunding professionals should typically be done through a competitive RFP solicitation process.
- Escrow agent – The escrow agent, typically a commercial bank, is responsible for holding and managing the escrow investments up to and including the date when the refunded bonds are redeemed.
- Escrow verification agent – The escrow verification agent, typically a firm of certified public accountants, is responsible for confirming that the investments purchased for the escrow account will be sufficient to fund the debt service payments on the refunded bonds, up to and including the date when the refunded bonds are redeemed. Additionally, the escrow verification agent typically confirms that the yield on the escrow portfolio does not exceed the bond yield of the (tax-exempt) refunding bonds.
- Escrow bidding agent – Funding an escrow with open market securities may require an escrow bidding agent that solicits bids for securities used in the escrow.