What it means
Imagine a city that issued bonds years ago at a high interest rate and wants to take advantage of cheaper borrowing today. The old bonds cannot be repaid immediately because they have a call date (the first date on which the issuer may repay them early).
Instead of waiting, the city can issue new bonds now and use the proceeds to prepare for the old ones. The money from the new bonds is placed in an escrow account (a protected account managed by a trustee) and invested in very safe securities, such as government bonds.
The escrow is sized so that interest and principal will be enough to pay the old bonds' interest until the call date and then repay them in full. Because the repayment is secured, the old bonds are treated as safe and are often described as defeased.
The benefit is a lower interest cost for the issuer, locked in while rates are low, without waiting for the call date. For investors holding the old bonds, the credit quality improves because the escrow, and not the issuer's budget, backs repayment, and their bonds often rise in price.
The issuer must weigh these savings against the cost of setting up the escrow. There are costs and rules.
The issuer pays fees to advisers and a trustee, and it may pay more interest on the new bonds than the escrow earns, which is called negative arbitrage. Tax rules in some countries restrict how often and how far in advance tax-advantaged bonds can be refunded, so the legal position needs checking.
Pre-funding is a classic tool for public finance teams, but the idea applies more widely. Any borrower who sets aside the money for a future repayment, for example a company building a cash reserve for a bond that matures next year, is pre-funding the debt in a general sense.
In practice
Real-world examples.
Example
A school district has bonds issued at 6% with a first call date in three years. It issues new bonds at 3.8% and creates an escrow, so that its debt costs fall after the call date by about 2.2% a year on the amount refinanced.
Example
A water authority prepares a pre-funding plan and finds that the savings, after fees and negative arbitrage, are only 1% of the bond amount. Its board decides to wait until the call date is closer.
Example
A manufacturer has a $50,000,000 bond maturing next year and builds up cash reserves in a segregated account during the year. When the bond matures, the company repays it from the reserve without needing to borrow.
Formula
Calculation
Annual interest saving = Old bond principal x (Old coupon rate - New coupon rate)
A city has $20,000,000 of bonds paying 5.5% that cannot be called for two years. It issues $20,000,000 of new bonds at 3.5% and places the proceeds in an escrow to pay the old bonds.
Old interest cost = $20,000,000 x 0.055 = $1,100,000 a year. New interest cost = $20,000,000 x 0.035 = $700,000 a year.
Annual interest saving = $1,100,000 - $700,000 = $400,000, although during the two years before the call date the city pays interest on both issues, and the escrow earnings only partly offset this, so the net benefit starts after the old bonds are repaid.Case study
Seen in the real world.
Riverton County is a fictional local government with $30,000,000 of older bonds at 5.8% that were callable in two and a half years. When market interest rates fell, the finance director asked advisers to model a pre-funding.
The analysis showed that new bonds at 3.6% would save $660,000 a year after the call date, but the cost of the escrow and the interest paid in the meantime reduced the benefit in the early years. In this illustrative case, the council approved the plan because the total savings over the remaining life of the debt were well above the costs, and the old bonds were repaid from the escrow on the call date.
The finance director reported the saving to residents in plain terms, and the council adopted a policy to review all older bonds each year to see whether similar opportunities existed.
Watch out
Common mistakes.
- Looking only at the lower coupon and ignoring escrow costs and negative arbitrage.
- Assuming the old bonds disappear at once, when they remain outstanding until the call or maturity date.
- Ignoring tax rules that may limit or prohibit advance refunding of certain bonds.
Questions
People also ask.
What does defeased mean?
It means the old bonds are backed by a locked escrow of safe securities, so their repayment no longer depends on the issuer's own resources.
Why would investors like a pre-funded bond?
Because repayment is secured by high-quality assets, the risk is lower and the bond often trades at a higher price.
Is pre-funding the same as refinancing?
It is a form of refinancing, but with the extra step of securing the old debt's repayment in an escrow before the call date.
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