What it means
Governments and companies sometimes want to replace old debt, most often because interest rates have fallen. They issue new bonds and use the cash to retire the old ones.
The old bonds may not be callable immediately, so the proceeds can be placed in a safe account until the first call date or maturity. The account is called an escrow, which means assets held by a neutral party for a specific purpose.
The assets are normally government securities whose payments are timed to cover the interest and principal on the old bonds. Once that is done, the old bonds are described as refunded or pre-refunded.
For the holder, a refunded bond looks very different from the day it was issued. Its payments are now backed by the escrow and not by the issuer's tax revenue or business income.
Because the escrow is full of safe securities, rating agencies often raise the bond to their top rating, whatever the issuer's own rating may be. The market price usually rises to reflect the better credit quality, and the bond tends to be valued by reference to its call date or maturity date.
Investors who want safety without government bond yields sometimes seek out refunded bonds. They should still check the escrow arrangements and the exact payment dates.
For the issuer, the main benefit is saving on interest, and the old debt also disappears from its list of obligations that rely on future income. By replacing a high-coupon bond with a lower-coupon one, the issuer can reduce its borrowing cost over time.
The rules on refunding, especially for tax-exempt debt, vary between countries and change over time, so the details need to be checked for each case.
In practice
Real-world examples.
Example
A city issues new bonds at a lower interest rate and places the proceeds in an escrow of government securities. The old bonds, which cannot yet be called, are now described as pre-refunded, and their price rises because their payments are now secured. Investors who hold them receive their interest on time until the escrow redeems them.
Example
A retired investor holds a municipal bond that has been refunded. She notices that it now carries the highest credit rating and plans to hold it until the call date because the escrow guarantees her payment. She notes the date in her diary, because that is when her money comes back.
Example
A hospital group refunds an older issue after interest rates drop, saving about $400,000 a year in interest. The finance director reports the saving to the board and explains that the old bonds remain outstanding until the escrow pays them off.
Case study
Seen in the real world.
Eastmoor County is an illustrative, fictional local government that had issued $30,000,000 of bonds at a high interest rate ten years earlier. When market rates fell, the county's treasurer proposed issuing new, cheaper bonds.
The old bonds could not be called for another three years, so the treasurer placed the proceeds of the new issue in an escrow of government securities arranged to pay the old bondholders on schedule. The old bonds became refunded, and their rating rose to the top level.
The county saved a meaningful amount of interest over the following years, and its credit position improved. The treasurer presented the saving to the council as the difference between the old interest bill and the new one, less the cost of setting up the escrow, which made the case easy to follow. The illustrative lesson is that refunding converts a risk based on the issuer's finances into one based on a pool of safe securities.
Watch out
Common mistakes.
- Thinking that a refunded bond has been paid off, when it remains outstanding until the escrow makes the final payment.
- Assuming the issuer's finances still determine the bond's safety, when the escrow now carries that role.
- Ignoring the call date, which usually decides when the investor will actually be repaid and therefore the true yield earned.
Questions
People also ask.
Why are refunded bonds considered so safe?
Their payments come from an escrow of government securities set aside for that purpose, not from the issuer's ongoing income. That is why they often carry the top credit rating.
What is a pre-refunded bond?
It is a bond that has been refunded before its first call date, so the escrow is used to cover payments until that date and then to redeem the bond.
Does refunding always save money?
Not always, since it depends on how much lower the new rate is and on the costs of issuing and managing the escrow. Issuers compare the present value of the saving with those costs before they go ahead.
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