What Is a Pre-Funded Bond?

Municipal bonds offer investors interest income that is free of federal and local income tax. To promote the sale of these bonds, the issuing state or municipal government can seek ways to reduce investor fears of default. For example, some issuers buy insurance to guarantee the timely payment of interest and repayment of principal, collectively known as “debt service.” Another route to safety is to pre-fund a bond issue.

Terminology

The terms used in connection with pre-funding a municipal bond are somewhat confusing. “Pre-funding,” “pre-refunding” and “advance refunding” are synonyms that all refer to setting aside funds to pay off a bond issue on its call date. The call date is the first date on which the issuer can redeem the outstanding bonds, even though the maturity date has not arrived. An advance refunding is one that occurs more than 90 days before the call date; otherwise, it’s a “current refunding.” Local governments issue new municipal bonds, called the “refunding issue,” to pay off the original bonds, called the “refunded issue.”

Method

In “net cash” advance refunding, the issuer uses the proceeds from the sale of a refunding issue -- the second bond issue -- to invest in Treasury debt and other safe federal securities, which it places in an escrow account. The issuer uses the escrowed securities, along with the interest they generate and perhaps in conjunction with other available moneys, to pay the debt service on the refunded issue -- the first bond issue -- up to the call date. In “full cash” advance refunding, the local government issues two new series of bonds, A and B. The A series is the refunding bond, in which the initial proceeds pay in full for the advance refunding of an earlier bond series. The B series is a “special obligation” bond issue that generates proceeds the issuer uses to pay the interest on the A-series bonds.

Overcoming Restrictions

The Internal Revenue Code places certain restrictions on advance refunding, such as the maximum yield the refunding bonds can pay. If the refunding bonds disregard these restrictions, they lose their tax-exempt status. The code eases these restrictions for current refunding -- that taking place within 90 days of the call date. To overcome restrictive regulations, an issuer can arrange a “forward refunding,” in which it agrees with an underwriter to issue a refunding bond series in the future, within the 90-day period preceding the call date. Alternatively, the issuer can arrange “synthetic refunding,” which is a deal between the issuer and a counterparty. The issuer agrees to certain future actions in exchange for a payment from the counterparty. The issuer uses the payment to pay debt service on the refunded bonds. In return, the counterparty gets favorable terms when the issuer performs a current refunding.

Crossover Refunding

Many municipal bonds have dedicated revenue streams, such as new taxes, that help pay for principal and interest. Under the “crossover refunding” method, once the issuer redeems refunded bonds, it reapplies the revenue stream to pay the debt service on the refunding bonds. During the period in which both the refunded and refunding bonds are outstanding, the issuer uses the interest on the escrowed proceeds of the refunding bonds to pay the debt service on those bonds.