Key Takeaways
- Refunded bonds are bonds with their principal cash amount pre-set aside by the original issuer, ensuring low risk for investors.
- These bonds use sinking funds to hold principal in escrow, offering safety similar to U.S. Treasuries.
- Refunding allows issuers, like municipalities, to refinance bonds at lower interest rates, saving on costs.
- Due to their structure, refunded bonds often carry an ‘AAA’ rating, though they provide little yield premium.
- Refunded bonds typically maintain a tax-exempt status for federal tax purposes.
What Is a Refunded Bond?
A refunded bond is a type of bond where the principal amount is set aside by the issuer in advance to ensure repayment, usually managed through a sinking fund or escrow account. Refunded bonds offer low-risk investment opportunities due to their secured principal, making them comparable in stability to U.S. Treasuries. These bonds are predominantly issued by municipal and corporate entities to manage existing debt efficiently.
A refunded bond should not be confused with a pre-refunding bond, which is a debt security that is issued in order to fund a callable bond. With a pre-refunding bond, the issuer decides to exercise its right to buy its bonds back before the scheduled maturity date.
We’ll explain how refunded bonds work and their benefits and risks, providing you with the necessary tools to make informed investment choices.
How Refunded Bonds Work
Refunded bonds are low-risk investments because the principal amount is already accounted for. The funds required to pay off refunded bonds are held in escrow until the maturity date, usually by purchasing Treasury or agency paper. Refunded bonds can also be referred to as pre-refunded bonds or prior issues.
By definition, the term “refunding” means refinancing another debt obligation. It is not unheard of for municipalities to issue new bonds in order to raise funds to retire existing bonds. The bonds which are issued to refund older bonds are called refunding bonds or pre-refunding bonds. The outstanding bonds which are paid off using proceeds from refunding bonds are called refunded bonds. Put differently, a refunded bond can be construed as a bond of a prior issue that is refinanced using a refunding bond.
Payments on refunded bonds are considered equivalent in quality to Treasuries, which are backed by the full faith and credit of the U.S. government, after passing through a binding escrow account. Refunded bonds will typically be ‘AAA’ rated due to this cash backing system and, as such, will offer little premium to equivalent-term Treasuries. In addition, refunded bonds maintain a tax-exempt status for federal tax purposes.
Who Benefits from Refunded Bonds?
A refunded bond is originally issued by a municipal, state, or local government authority as either a general obligation bond or a revenue bond. The inverse relationship that exists between bond prices and interest rates means that when prevailing interest rates in the economy drop, prices on outstanding bonds will increase. This also means that an issuer of an existing bond will be stuck paying a higher interest rate than what issuers of new bonds are paying their investors. Since bond issuers look to borrow funds with as low interest as possible, they will typically redeem an existing bond before it matures and refinance the bond with a lower interest rate that reflects the lower rates in the market. In effect, the proceeds from the issuance of the new lower interest rate bonds will be used to pay off the higher interest rate bonds.
An issuer that wants to take advantage of lower interest rates during the call protection period may issue refunding municipal bonds. The proceeds from the new issue will be placed in an escrow account until the call date of the refunded bond is reached. To be more specific, the proceeds from the refunding bond are used to purchase Treasury securities, which are deposited and held in escrow. The interest generated from the treasuries helps in paying the interest on the refunded bonds up to the call date, at which point the proceeds held in escrow will be used to pay off existing holders of the refunded bond. The date of refunding will usually be the first callable date of the bonds.
The Role of Callable Bonds in Refunding
Callable bonds often have a call protection period, stated in the trust indenture, that prevents a bond issuer from retiring its bonds early before a specified time. For example, a 10-year callable bond may have a four-year call protection period. This means the issuer cannot redeem the bonds for four years, after which they may choose to exercise its right to call the bond on the given first call date—the first date a bond can be called after the call protection period expires.