Refunding Methods

Call features give issuers the right to redeem bonds early. Refunding is the mechanism they use to do it: issuing new bonds to pay off old ones. The critical distinction for the exam is between current and advance refunding.

Current Refunding

  • New bonds are issued and the proceeds are used to retire the old bonds within 90 days of the call date
  • The old bonds are called or mature within the 90-day window
  • Straightforward replacement of old debt with new debt at lower rates
  • No escrow is needed because the old bonds are immediately redeemable

Exam Tip: Gotchas

  • 90 days is the bright line. Within 90 days of the call date = current refunding. More than 90 days = advance refunding. The exam tests this threshold frequently.

Advance Refunding (Pre-Refunding)

  • New bonds are issued more than 90 days before the old bonds can be called
  • Proceeds are placed in an escrow account invested in U.S. government securities (Treasuries or agencies)
  • The escrowed securities generate cash flows to pay debt service on the old bonds until the call date, at which point the old bonds are redeemed
  • Pre-refunded bonds are typically rated AAA because they are backed by escrowed U.S. government securities, not the issuer's own credit

Think of it this way: The issuer locks the refunding proceeds in a vault of Treasuries. Those Treasuries generate enough cash to keep paying the old bondholders until the call date arrives. Because U.S. government securities back the payments, the old bonds effectively become as safe as Treasuries themselves, which is why they get an AAA rating.

Tax law change:

  • Tax-exempt advance refunding of tax-exempt bonds was eliminated by the Tax Cuts and Jobs Act (TCJA) of 2017, effective January 1, 2018
  • Issuers may still advance refund using taxable bonds, but the higher interest cost makes it less attractive

Exam Tip: Gotchas

  • Pre-refunded bonds are rated AAA because of the escrowed Treasuries, not the issuer's credit. The issuer's own rating is irrelevant once the escrow is in place.
  • Tax-exempt advance refunding is no longer allowed (post-2017). Issuers must use taxable bonds for advance refundings, which are more expensive.

Current Refunding at the Call Date

  • Issuer waits until the call date arrives and then issues new bonds to pay off the old callable bonds
  • No escrow is needed because the old bonds are immediately redeemable
  • Simpler and less expensive than advance refunding

Escrowed to Maturity (ETM)

  • Similar to advance refunding, but the escrowed securities are structured to pay the old bonds through their final maturity date (the bonds are not called early)
  • The old bonds remain outstanding but are defeased (economically removed from the issuer's balance sheet)
  • ETM bonds are considered among the safest municipals because they are backed by escrowed Treasuries

Exam Tip: Gotchas

  • ETM bonds are not called early. Unlike standard advance refunding where old bonds are redeemed at the call date, ETM bonds ride all the way to maturity with Treasury-backed payments.

Crossover Refunding

  • New (refunding) bonds are issued, and proceeds are placed in escrow
  • The escrow initially generates cash flows to pay debt service on the new bonds (not the old bonds)
  • On the crossover date (typically the call date of the old bonds), the escrow "crosses over" to retire the old bonds
  • During the interim, both old and new bond issues are outstanding, but the issuer's net debt service is not doubled because the escrow covers the new bonds until crossover

Exam Tip: Gotchas

  • In a crossover refunding, the escrow pays the NEW bonds first. This is the opposite of standard advance refunding, where the escrow services the old bonds. On the crossover date, the escrow switches to retire the old bonds.

Direct Exchange vs. Sale of New Issue

  • Direct exchange: Old bonds are exchanged directly for new bonds (rare)
  • Sale of new issue: New bonds are sold in the public market, and proceeds retire the old bonds (standard practice)