What it means
Most long-dated bonds cannot be repaid whenever the issuer likes. They carry a call protection period, often ten years, during which the issuer must keep paying the original coupon regardless of what has happened to market rates.
Advance refunding solves that problem indirectly. The issuer sells new bonds at today's lower rate, buys a portfolio of government securities with the proceeds, and locks that portfolio in escrow so its cash flows exactly match the remaining payments on the old bonds up to and including the call date.
Once the escrow is in place the old bonds are described as defeased, meaning they are still legally outstanding but are now backed by the escrow rather than by the issuer's revenues. Rating agencies typically treat defeased bonds as extremely low risk, and the issuer's covenants under the old indenture usually fall away.
The economics turn on whether the interest saved exceeds the cost of getting there. Costs include underwriting and legal fees, and negative arbitrage, which is the loss from earning a low escrow yield on the proceeds while paying a higher coupon on the new bonds during the escrow period.
Rules differ by market and have changed. In the United States, federal tax legislation in 2017 ended tax-exempt advance refunding for municipal bonds, so issuers now use taxable refunding bonds, forward delivery bonds or tender offers to achieve a similar result.
Public finance teams generally look for net present value savings of at least 3% to 5% of the refunded principal before proceeding.
In practice
Real-world examples.
Example
A state transport agency issued toll revenue bonds at 5.75% during a period of high rates and cannot call them for another four years. With market rates now near 3.9%, it advance refunds using taxable bonds, escrows the proceeds in treasury securities, and locks in the saving rather than gambling on rates in four years' time.
Example
A university issued dormitory bonds with restrictive covenants that cap additional borrowing. It advance refunds the issue partly to reduce interest cost and partly to defease the old covenants, giving the finance office room to fund a new science building.
Example
A municipal utility runs the analysis and finds present value savings of only 1.8% of par after escrow costs. The finance director declines to proceed and instead files a forward delivery structure to be priced closer to the call date, because burning the refunding opportunity for a thin saving would remove flexibility later.
Formula
Calculation
Net present value savings = Present value of old debt service - Present value of new debt service - Issuance and escrow costs
Savings percentage = Net present value savings / Par amount refunded
Worked example. A water authority has $50,000,000 of bonds outstanding with a 5% coupon and 10 years left to run, callable in three years. It can issue refunding bonds today at 3.5%.
Annual interest on the old bonds = $50,000,000 x 5% = $2,500,000.
Annual interest on the new bonds = $50,000,000 x 3.5% = $1,750,000.
Annual saving = $2,500,000 - $1,750,000 = $750,000 for 10 years.
Discounting that saving at 3.5% over 10 years gives an annuity factor of 8.3166, so:
Present value of savings = $750,000 x 8.3166 = $6,237,454.
Issuance costs and negative arbitrage in the escrow = $1,500,000.
Net present value savings = $6,237,454 - $1,500,000 = $4,737,454.
Savings percentage = $4,737,454 / $50,000,000 = 9.47%.
At 9.47% of refunded par, comfortably above a typical 3% threshold, the transaction clears the authority's policy test and the board approves it.Case study
Seen in the real world.
This case is illustrative and Brackenmoor is a fictional issuer. The Brackenmoor Regional Water District had $80,000,000 of 2016 revenue bonds outstanding at a 5.25% coupon, callable in 2027, with final maturity in 2036. By 2026 comparable taxable rates had fallen to around 3.6%, and the district's advisers modelled an advance refunding.
The analysis showed gross interest savings of roughly $1,320,000 a year, offset by $900,000 of issuance costs and an estimated $1,400,000 of negative arbitrage over the escrow period. On a present value basis the net saving came out at about 6.2% of par, above the district's 4% policy floor.
The board approved the refunding, and in this illustrative story the money saved was ring-fenced to fund mains replacement rather than to reduce tariffs. The treasurer's closing note was that the transaction was worth doing mainly because the district removed a restrictive additional bonds test at the same time, a benefit that never appeared in the savings percentage.
Watch out
Common mistakes.
- Reading the coupon difference as the saving. Issuance costs, escrow yields and the shape of the maturity schedule can easily consume a third or more of the headline interest reduction.
- Thinking the old bonds disappear on closing day. They stay outstanding until the call date and are simply defeased, which is why the escrow has to be structured to service them precisely.
- Ignoring the option value being given up. Refunding now means you cannot refund the same bonds again if rates fall further, so a marginal saving today can be an expensive decision later.
Questions
People also ask.
What is the difference between advance refunding and current refunding?
A current refunding takes place within 90 days of the call date so proceeds repay the old bonds almost immediately, whereas an advance refunding requires an escrow because the call date is further away.
What is negative arbitrage?
It is the loss suffered when the escrow's investment yield is lower than the interest rate on the new refunding bonds, and it is the single biggest reason transactions fail to clear savings thresholds.
Do corporations use advance refunding?
Corporate issuers achieve similar outcomes through tender offers, make-whole calls and defeasance, but the escrowed advance refunding structure is most closely associated with public sector borrowers.
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