What it means
Most long term bonds cannot be repaid early whenever the borrower feels like it. They carry a call date, which is the first day the issuer is allowed to buy them back, and that date is often five or ten years after the bonds were first sold.
Until then the issuer is stuck paying the original interest rate. An advanced refunding is the way round that wait.
The issuer sells new bonds at the lower rate available now, places the proceeds in an escrow account invested in safe government securities, and the escrow makes the interest payments on the old bonds until the call date arrives. On the call date the escrow repays the old holders in full, leaving only the new and cheaper bonds outstanding.
For anyone outside the treasury team, the reason this matters is that it changes the cost of money for a whole organisation. A city that cuts its annual interest bill frees cash for services without touching a tax rate, and a utility doing the same can hold its prices flat for longer.
Those are decisions a general manager feels, not just a debt specialist. Deals are judged on net present value savings, meaning the value today of all the interest the issuer will no longer pay, less the cost of funding the escrow and the fees of selling the new bonds.
Many public finance policies set a minimum threshold, often in the region of 3% of the refunded principal, before officials will approve a refunding. Below that level the effort and the risk are not considered worth it.
The close cousin is a current refunding, where the old bonds are already within about 90 days of their call date, so no long escrow period is needed. The two are often confused, but only the advanced version carries the cost and complexity of holding an escrow for years.
Tax treatment is the other nuance worth knowing. Whether the interest on an advanced refunding bond can be paid free of tax depends on the rules set by the relevant tax authority, and those rules have been tightened and loosened more than once, so the answer is a question for current advice rather than a permanent fact.
In practice
Real-world examples.
Example
A county road authority has $40,000,000 of bonds paying 5.5% that cannot be called for four years. Market rates fall, so it advance refunds the issue at 3.5% and escrows the proceeds. The saving is locked in now instead of depending on rates still being low in four years.
Example
A university treasurer reviews the debt on two halls of residence and finds the refunding saving would be only 1.2% of principal, below the board policy threshold of 3%. She recommends waiting rather than spending $250,000 of fees to achieve very little, and documents the decision for the next review.
Example
A regional water utility advance refunds an old issue and uses part of the saving to defer a planned 4% increase in household charges for a year. The finance committee presents the refunding as a customer pricing decision rather than a technical treasury one, which makes the approval vote straightforward.
Formula
Calculation
Annual interest saving = Principal refunded x (Old interest rate - New interest rate)
Net saving = (Annual saving x Years of saving) - Escrow shortfall and issuance costs
A school district has $10,000,000 of bonds outstanding paying 5% a year with 10 years left to run, and the call date is 3 years away. It issues $10,000,000 of new bonds at 3% and escrows the proceeds to cover the old bonds until the call. Old annual interest is $10,000,000 x 5% = $500,000. New annual interest is $10,000,000 x 3% = $300,000. The annual saving of $200,000 is earned over the 7 years that follow the call date, because the escrow absorbs the first 3 years, so the gross saving is $200,000 x 7 = $1,400,000. Escrow funding shortfall and issuance costs total $300,000, so the net saving is $1,400,000 - $300,000 = $1,100,000, which is 11% of the refunded principal and comfortably above a 3% policy threshold.Case study
Seen in the real world.
This is an illustrative, fictional example. Northvale County District, an invented public borrower, carried $60,000,000 of bonds issued at 5.25% with a call date four years away. Its finance director modelled an advanced refunding at 3.25% and found gross interest savings of $1,200,000 a year once the call date had passed.
Savings would run for the six years between the call date and final maturity, giving $7,200,000 gross. Escrow funding and issuance costs came to $900,000, leaving roughly $5,000,000 of net present value saving, well above the county threshold of 3% of principal. The board approved the deal and earmarked the saving for the road maintenance backlog rather than new spending, which made the vote easier to explain to residents.
In the illustrative story, market rates rose sharply two years later and the same transaction would no longer have worked. That is the practical lesson: a refunding window is an opportunity with a shelf life, not a permanent option sitting on the shelf.
Watch out
Common mistakes.
- Assuming a lower interest rate automatically means a worthwhile deal, when escrow costs and issuance fees can swallow most of the saving.
- Treating the gross interest saved as cash in hand, instead of discounting it to a present value and netting off every transaction cost.
- Confusing an advanced refunding with a current refunding, and budgeting for a long escrow that is not actually needed.
Questions
People also ask.
Does the old debt disappear from the balance sheet?
Usually the escrow is treated as a legal defeasance so both the old bonds and the escrow come off the books, but the accounting depends on the standard applied, so confirm the treatment with the auditor.
Can the same bonds be advance refunded twice?
Rarely, because tax rules and bond documents commonly restrict how often an issue may be refunded, and a second attempt often loses any tax advantage.
Who benefits, the issuer or the original bondholders?
The issuer gains the lower interest cost, while the original holders keep receiving their coupon until the call date and are then repaid, so they lose a high yielding asset earlier than they might have wished.
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