Bond refinancings or “refundings” are used by state and local governments to achieve debt service savings on outstanding bonds. Though less frequent, refunding bonds can also be issued to remove or revise burdensome bond covenants or to restructure debt service payments.
GFOA recommends that governments include guidelines and criteria in their debt management policies that address when a refunding is permitted based on potential debt service savings and other criteria, such as how to monitor refunding opportunities on outstanding debt and other considerations as outlined below.
As is stated throughout 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 registered municipal advisor. Many unique refunding structures may be presented to governments, and prior to pursuing such refunding transactions, the risks and benefits of each should be thoroughly reviewed by the government with the assistance of a municipal advisor, which has a fiduciary duty to the government.
The Mechanics of Refunding Bonds
Municipal bonds are typically issued with an optional redemption date or “call date” (i.e., prepayment date without penalty) approximately 10-years from the date of issuance. The optional redemption provision allows the government issuer to refinance the outstanding bonds with refunding bonds. Generally, when enough time passes and the call date approaches, the government will assess current market rates at that time, and if current market rates are below the interest rates on the outstanding bonds, the government can issue refunding bonds at a lower interest rate and realize debt service savings.
A refunding bond issuance is generally characterized as either a current refunding or an advance refunding.
- A current refunding occurs when the outstanding (refunded) bonds are redeemed within 90 days of the date the refunding bonds are issued.
- An advance refunding occurs when the refunded bonds are redeemed more than 90 days from the date the refunding bonds are issued and an irrevocable escrow account is established to make payments until the call date of the bonds. Unlike a current refunding, an advance refunding typically requires a prepayment penalty which should be factored into anticipated savings.
Note that changes to federal tax law in 2017 eliminated the ability of governments to issue tax-exempt bonds for an advance refunding of outstanding tax-exempt debt (the goal of the change was to eliminate the ability of issuers to have two sets of tax-exempt bonds issued for the same initial capital funding purpose outstanding at the same time, i.e., during the escrow period before the refunded bonds are called). Governments are still allowed to issue taxable debt to advance refund tax-exempt debt; however, the higher interest cost relative to tax-exempt bonds should be considered and evaluated .
Alternatives to tax-exempt advance refundings: With the elimination of tax-exempt advance refunding bonds, some banks and broker/dealers have developed alternative financing structures that realize a portion of the savings previously available through tax-exempt advance refundings have been developed. Governments should be aware these alternative structures may involve additional risks, reduced savings, and other disadvantages. Governments should evaluate the potential risk/benefits of these alternative structures relative to the option of simply waiting until the call date/prepayment date of the outstanding bonds and executing a current refunding with tax-exempt bonds.
Debt Policy Considerations
Governments should periodically review any existing debt policies for refundings to determine if the policies are still relevant given potential changes in tax law, federal borrowing programs, and other market developments. Guidelines and criteria may include some or all the following and should be discussed with the municipal advisor:
Debt Policy Considerations – Refunding Debt Service Savings
The debt policy for refunding bonds should include decision guidelines regarding when to refund outstanding bonds based on a minimum savings threshold. Policies should consider whether refunding thresholds will be applied to an entire issue or on a maturity-by-maturity basis. However, governments should also consider including flexibility in their debt policies to provide the ability to refund debt for reasons other than debt service savings, where the circumstances warrant, as further discussed below.
Governments may wish to adopt different minimum net present value (NPV) savings criteria for current refundings than advance refundings. When outstanding bonds become currently callable, the value of the call option decreases in value over time. Therefore, governments may be more inclined to have lower savings thresholds for a current refunding than in an advance refunding.
Examples of differing approaches to refunding savings thresholds include:
- Minimum NPV savings threshold of a fixed percentage of the par amount of the refunded bonds, such as 3% or 5%, to be met before any refunding transaction is considered.
- A graduated NPV savings criteria based on the number of years between the refunded bond call date and final maturity. For example, for bonds with 9 or more years between the call date and final maturity, the minimum NPV savings criteria may be 4%, whereas bonds with only 2 years between the call date and final maturity may require only a 1% minimum NPV savings requirement.
- A graduated NPV savings criteria based on both the number of years until the maturity date as well as the number of years from the refunding execution date to the call date. As mentioned above, due to the decreasing value of the call option, governments may be more inclined to execute a refunding transaction with lower savings levels the closer they get to the call date, or conversely may require a higher savings level to refund bonds years in advance of when the refunded bonds can be called.
- A graduated NPV savings criteria based on the coupon rate of the refunding candidates (i.e., a 5% coupon bond naturally produces a greater savings rate as compared to a 4% coupon bond).
- A minimum dollar amount (as opposed to percentage) of NPV savings. For example, a debt policy may be written to require a minimum of $100,000 of NPV savings or 2 times the costs of issuance of the refunding transaction before pursuing.
Advance refundings require additional considerations when evaluating the viability of the refunding, which can be informed by analysis performed by the government’s municipal advisor:
- Breakeven Analysis. Performing a "breakeven analysis” will provide a government with a sense of how much interest rates can rise between the contemplated advance refunding date vs. a future tax-exempt current refunding. A large breakeven rate increase calculation can indicate that the government is better off waiting to the call date and executing a tax-exempt current refunding. Breakeven rates are particularly high when (1) short-term rates are low and (2) there is a large difference between tax-exempt and taxable borrowing rates.
- Escrow efficiency. In a proposed advance refunding, negative arbitrage is a measure of how much potential debt service savings are lost in funding the escrow until the call date if the escrow cannot be invested at a yield equivalent to the yield on the refunding bonds. Governments may want to set a guideline that negative arbitrage is less than a certain percentage of NPV savings before a refunding is undertaken.
- Refunding efficiency. Governments should understand that the call feature included in most municipal bonds has economic value. Consequently, they may want to set a minimum percentage of the potential call option value to be captured with an advance refunding before proceeding with the refunding. These estimates of the value of the call option depend on complex calculations that should be requested from a municipal advisor.
Debt Policy Considerations – Refunding Savings Structure
GFOA recommends that issuers structure refundings with “level savings,” where savings are realized in approximately equal annual amounts over the life of the refunding bonds. A government’s municipal advisor can also model other savings structures tailored to the government’s specific business and financial needs, any state or local requirements, and/or provisions of existing financing agreements or bond covenants. 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.
Monitor Refunding Opportunities - Governments should establish a process to identify and monitor potential refunding opportunities within their outstanding debt portfolio on a routine basis and 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 a government’s debt policies.
Debt Policy Considerations – Other Refunding Matters
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:
(1) The optional redemption provision (call date and price).
The typical optional redemption (i.e., “call date”) on a tax-exempt bond is generally 10 years from the date of issuance and GFOA recommends that bonds include a call date not later than approximately 10 years. Earlier call dates may be available, but they likely result in higher interest cost. The benefits of an earlier call feature should be weighed against potential negative effects and GFOA recommends that governments request from their municipal advisor an analysis of the benefits of any call structures outside of the conventional 10-year call date. For taxable bonds, the call provisions can vary, and the current and possible future costs of different call provisions should be evaluated.
(2) The coupon rate of each bond maturity after the call date.
Aside from future borrowing rates, future refunding opportunities depend on the coupon rates on the bonds to be refunded (not the original yields at which those bonds were sold). Bonds with higher/premium coupons (e.g., 5%) are more likely to be refunded than bonds with lower coupons, as a greater range of future borrowing rates can provide refinancing savings. Thus their call option at issuance has a higher value, however the higher value call option comes at a potentially higher cost, as 5% bonds result in a higher yield-to-maturity if the bonds are not refunded. Governments are encouraged to consult with their municipal advisor and others in their finance team to determine market preferences at the time of issuance and whether a high (i.e., premium) or low (i.e., par or discount) coupon structure provides the best cost of capital for the government.
Refunding Bonds for Other Purposes - Debt policies should also contemplate when a government will consider a refunding whose primary purpose is not debt service savings. Governments 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.
Build America Bonds - Governmental issuers of taxable or tax credit bonds (including Build America Bonds or “BABs”) will, in most cases, be able to issue tax-exempt advance refunding bonds to refinance those obligations. However, the retirement of BABs through a refunding will result in the loss of the federal interest subsidy payments, which should be considered when calculating refunding savings. Refunding analysis of BABs could be further complicated by the presence of make-whole call provisions, which eliminate the possibility of debt service savings. Governmental issuers of tax credit bonds and other taxable debt should consult with bond counsel and their municipal advisor to determine if their bonds are eligible to be advance refunded and to verify call and savings parameters of any advance refunding transaction.
Escrow Funding Considerations
Proceeds of 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 investment earnings minimize the escrow cost.
- 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). SLGS are typically preferred due to their ease and reliability of execution, as well as the ability to tailor such investment to specific escrow cashflow dates and permitted yields (up to the maximum SLGS rate currently being offered).
- When SLGS or other more traditional Treasury investments are not efficient from a yield perspective, Governments should consult with their municipal advisor about alternative permitted escrow investments, which are typically specified in the bond indenture/resolution for the refunded bonds. They should consider the cost of acquiring the investments, the yields, and the matching of timing of investment cash flows with debt service payments, as well as execution risk.
Refunding Bond Financing Team
At the outset of any financing, GFOA recommends that governments solicit the advice of their municipal advisor and bond counsel to identify key legal and financial issues early in the financing process. When evaluating the outside financing team members to include in the transaction, factors such as cost, experience, references, ability to meet deadlines and Disadvantaged Business Enterprises (DBE) should all be taken into consideration. Refunding bond transactions also typically involve additional professional service providers.
- 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 independently 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, in any case where there is a yield limitation on an escrow, the escrow verification agent also will typically confirm that the yield on the escrow portfolio does not exceed the permitted yield.
- 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. If a municipal advisor is engaged for the transaction, they may be able to provide this service.
- Board approval date: Friday, March 8, 2019