Bond refinancings or “refundings” are used by state and local governments most frequently 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.
Refunding bonds are characterized as either current refundings or advance refundings. A current refunding is one in which the outstanding (refunded) bonds are redeemed within 90 days of the date the refunding bonds are issued. In an advance refunding, the refunded bonds are redeemed more than 90 days from the date the refunding bonds are issued. Changes to federal tax law in late 2017 eliminated the ability of governments to issue tax-exempt advance refunding bonds. Taxable advance refundings of tax-exempt or taxable bonds are still permitted.
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 taken into account in calculating refunding savings. Refunding analysis of BABs could be further complicated by the presence of make-whole call provisions. 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.
With the elimination of tax-exempt advance refunding bonds, several alternative financing structures have emerged which attempt to realize a portion of the savings previously available through tax-exempt advance refundings. Issuers should be aware these alternative structures may involve additional risks, reduced savings and other disadvantages. In all cases, issuers should evaluate the potential risk/benefits of these structures relative to the option of simply waiting until the call date of the outstanding bonds and executing a tax-exempt current refunding if and when rates permit.
Governments should familiarize themselves with the refunding terminology and market for bond refundings, using the resources section at the end of this best practice.
The Government Finance Officers Association (GFOA) recommends that issuers include guidelines and criteria in their debt management policies that address when a refunding is permitted based on potential debt service savings or other criteria, preservation of future refunding flexibility when issuing any new money debt, and monitoring of refunding opportunities on outstanding debt.
GFOA also recommends that when evaluating a refunding transaction, issuers should analyze their refunding objectives, the efficiency of any related escrow, and the unique aspects of executing the refunding transaction.
Additionally, 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 issuers, and the risks and benefits of each should be thoroughly reviewed with a municipal advisor before pursuing a refunding transaction.
Debt Policy Considerations – Refunding Debt Service Savings
Issuers should develop decision guidelines in their debt policies to determine when to refund outstanding bonds. Issuers may also need to review any existing debt policies for refundings to determine if the policies are still appropriate should laws change. Guidelines and criteria may include some or all of the following, and should be discussed with the municipal advisor.
- Net present value debt service savings – advance refundings. Minimum net present value (NPV) debt service savings are typically measured in relation to the par amount of the refunded bonds. The minimum savings threshold can be a fixed percent, such as 3% or 5%, and/or a minimum dollar savings threshold. Alternatively, some issuers use a grid of savings requiring higher savings for refundings with longer periods to the call date or longer periods from the call date to maturity. Policies should consider whether refunding thresholds will be applied to an entire issue or on a maturity-by-maturity basis.
- Net present value debt service savings – current refundings. Issuers may wish to adopt different 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, issuers may be more inclined to have lower savings thresholds than in an advance refunding. Three differing approaches to current refunding thresholds include:
- 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 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 before pursuing a current refunding.
- No difference between advance refunding and current refunding criteria.
- Negative arbitrage efficiency. In a proposed advance refunding, negative arbitrage is how much of potential debt service savings are lost in funding the escrow to the call date. Issuers may want to set a guideline that negative arbitrage is less than a certain percentage of NPV savings before a refunding is undertaken.
- Rate efficiency/sensitivity analysis. Issuers should conduct or receive an analysis of how much interest rates would have to rise by the call date to produce savings matching those that could be achieved with an advance refunding. This could result in simply waiting until the call date to refund the bonds.
- Refunding efficiency. Issuers should understand that the call feature included in most municipal bonds has economic value, and they may want to set a minimum of how much of the potential value of the call option should be captured with an advance 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
- Establish Guidelines on Savings Structure. In addition to criteria to address minimum NPV savings criteria, an issuer’s debt policy should address how the available savings will be realized over the life of the refunding bonds. The most common, known as “uniform savings,” realizes savings in approximately equal annual amounts over the life of the refunding bonds. Another similar savings structure is known as “proportionate savings” and realizes savings in amounts approximately proportionate to the debt service on the refunded bonds. Alternatively, at times an issuer might wish to “accelerate” the available savings to provide greater near-term debt service relief. When savings are accelerated, or front-loaded, care should be taken to ensure that the debt service on later maturities is no greater than that of the refunded bonds. The municipal advisor can also model other savings structures, tailored to the issuer’s 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.
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:
- The optional redemption provision (call date and price).
- The coupon (not the yield) of each bond maturity after the call date.
The typical optional call on a tax-exempt bond is generally no longer than 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 somewhat higher yields-to-maturity at the time of issuance, and other financial effects, depending on the market. The benefits of an earlier call feature should be weighed against potential negative effects, and GFOA recommends that issuers request from their municipal advisor an analysis of the benefits of any alternative call structures. For taxable bonds, the call provisions can vary and the current and possible future costs of different call provisions should be evaluated.
Future refunding opportunities also depend on the coupons – not the yields – on the bonds to be refunded. Bonds with relatively high coupons (e.g. 5%) are more likely to be refunded than bonds with lower coupons. Issuers 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 higher or lower coupon (premium or discount bonds) provide the best economic conditions for the issuer.
- Monitor Refunding Opportunities. Issuers should establish a process to identify and monitor potential refunding opportunities in the outstanding debt portfolio 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 issuers’ debt policies.
- Non-Savings Refundings. Debt policies should also address when an issuer will consider a refunding whose primary purpose is not debt service savings. Issuers 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 understoodand articulated to all stakeholders, as well as how such a decision fits into a long-term financial plan.
Executing the Refunding Bond Issue
- Current Refunding Proceeds. Proceeds of current refunding bonds are often placed in the debt service or related/similar fund for use within 90 days to redeem the refunded bonds. The investment of these proceeds must comply with the investment requirements of the debt service or related/similar fund, and any investment must also provide for the proceeds to be available on the redemption date. If investment options are available, please see the discussion below under “Advance Refunding Escrow”. Issuers should review investment alternatives with bond counsel and their municipal advisor.
- Advance Refunding Escrow. Proceeds of advance 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 earnings minimize the cost of the escrow. 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). On occasion, the Treasury SLGS window has been closed to issuers due to Federal budgetary inaction, and escrows are either funded by cash or bond proceeds or funded with the purchase of eligible open market investments. However, if issuers are able to realize the arbitrage yield, and SLGS are available, SLGS should be used due to the ease and reliability of execution. Issuers should review these alternatives with their municipal advisor and should consider the cost of acquiring the investments, the yields, and the matching of timing of investment cash flows with debt service payments.
At the outset of any financing, GFOA recommends that issuers solicit the advice of their municipal advisor and bond counsel to identify key legal and financial issues early in the financing process. Refunding bonds may have special considerations such as call/defeasance notices or escrow accounts, in addition to those associated with other types of financings. Issuers should be aware of these issues, which should be fully discussed with the municipal advisor and bond counsel. Ultimately, the issuer should fully understand these issues before proceeding with the financing.
- Refunding Bond Financing Team. In addition to the usual outside financing team members, refunding bonds typically involve specific services related to the refunding transaction. Most of the following relate to advance refunding transactions, but depending on deal specifics, may also be utilized in a current refunding transaction. Corresponding to other GFOA best practices on hiring outside bond professionals, securing refunding professionals should typically be done through a competitive RFP solicitation process.
- 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, the escrow verification agent typically confirms that the yield on the escrow portfolio does not exceed the bond yield of the (tax-exempt) refunding bonds.
- 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 specific service.