Advance refunding 

Advance refunding 

Due to the large savings it provides and the decreased risk of default, advance refunding is a financial strategy that has grown in popularity among investors. This tactic entails refinancing current debt by issuing new bonds at a lower interest rate. Municipalities and other governmental organisations use it to manage their debt and exploit advantageous market conditions. 

What is advance refunding? 

Advance refunding is a financial strategy involving issuing new bonds to pay off existing ones before they mature. This is done when interest rates are lower than the rate on the existing debt, allowing the issuer to save money on interest payments. The proceeds from the new bonds are used to pay off the existing bonds, and the savings generated by the lower interest rate can be used to fund capital projects or reduce overall debt service costs. Municipalities and other government entities commonly use advance refunding to manage their debt and exploit favourable market conditions. 

Understanding advance refunding 

Advance refunding uses the revenues from new bond issuance to pay off a debt from a previous issue. The only time this is feasible is after 90 days have passed. Usually, the interest rate on issuing the new bond is lower than that on the prior unpaid obligation. Advance refunding is typically used by municipalities to lower borrowing costs and take advantage of low-interest rates. An issuance of bonds in which new bonds sell at a lower price than existing bonds is known as advance refunding. The bond issuer places the money received from the sale of the more recent (refunding bond) issue in an escrow account as soon as the older (refunded bond) issue is called. 

Advantages of advance refunding 

The advantages of advance refunding are as follows: 

  • Advance refunding allows a borrower to take advantage of lower interest rates by refinancing existing debt before it matures. 
  • By refinancing at a lower interest rate, a borrower can reduce its debt service costs, resulting in significant savings over the life of the debt. 
  • By reducing debt service costs, a borrower’s credit rating may improve, making it easier and less expensive to access credit in the future. 
  • Advance refunding allows a borrower to take advantage of market conditions when they are favourable rather than waiting until debt matures. 
  • Refinancing existing debt at a lower interest rate reduces the risk of default, lowering the borrower’s debt service costs and improving its financial position. 

Regulation of advance refunding 

The regulation of advance refunding varies by country and jurisdiction. In the United States, the issuance of municipal bonds and advance refunding is regulated by the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB). The SEC regulates the sale of municipal securities and requires issuers to provide investors with accurate and timely information about the bonds.  

The MSRB sets rules for municipal securities dealers, including disclosure requirements and fair dealing standards. In the United States, the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) limits the amount of advance refunding that can be done on tax-exempt bonds. TEFRA restricts the ability of issuers to refinance bonds more than once every 10 years. The regulation of advance refunding is intended to protect investors and ensure that issuers use the savings generated to benefit their communities. 

Example of advance refunding 

A municipality that has previously issued bonds at a higher interest rate could serve as an example of advance refunding. The municipality can issue new bonds at a lower rate to pay off the previous debts before they mature because interest rates are currently lower. The name of this procedure is advance refunding. The municipality can cut its overall debt and save money on interest payments.  

An example would be the US$10 million in bonds a municipality issued at a 5% interest rate. The municipality can now issue new bonds at a cheaper interest rate to pay off the previous bonds before they mature because interest rates are already at 3%. The municipality can avoid paying US$200,000 in interest each year by doing this. 

Frequently Asked Questions

Advance refunding works by issuing new bonds at a lower interest rate to pay off existing bonds before they mature. The proceeds from the new bonds are placed into an escrow account, which is used to pay the principal and interest on the existing bonds until they mature. Once the existing bonds are paid off, the issuer can use the savings generated by the lower interest rate on the new bonds to pay for capital projects or to reduce overall debt service costs. 

Some of the limitations of advance refunding include restrictions on how often bonds can be refunded, the need to pay issuance costs for new bonds, and the potential for interest rates to rise after the refunding, reducing the savings achieved. Advance refunding can be more difficult to execute when market conditions are unfavourable or the issuer’s creditworthiness has deteriorated since the original bond issuance. 

The benefits of advance refunding include taking advantage of lower interest rates, which can reduce debt service costs and improve an issuer’s credit rating. Advance refunding also allows issuers to refinance debt when market conditions are favourable rather than waiting for bonds to mature. This can result in significant savings over the life of the debt. Advance refunding can reduce the risk of default by lowering an issuer’s debt service costs and improving its financial position. 

Advance refunding involves issuing new debt to pay off existing debt before it matures, while current refunding involves issuing new debt to pay off existing debt when it matures. Advance refunding is typically used when interest rates are lower than the rate on the existing debt. In contrast, current refunding is used when interest rates are the same or lower than the rate on the existing debt and the bonds are close to maturity. 

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