Advance Refundings of Municipal Bonds

Abstract

Municipal bonds are often "advance refunded." Bonds that are not yet callable are defeased by creating a trust that pays the interest up to the call date, and pays the call price. New debt, generally at lower interest rates, is issued to fund the trust. Issuing new securities to fund payments on existing liabilities generally has zero net present value. In this case, however, value is destroyed for the issuer through the pre-commitment to call. We estimate that on average in an advance refunding the option value lost to the municipality is approximately 0.75% of the par value not including fees. This translates to an aggregate value lost of $7-9 billion, depending on the option pricing model used, from 1995 to 2013 for the bonds in our sample, which are roughly two-thirds of the advance refunded bonds that traded during the period. The worst 5% of the transactions represent a destruction of $5.3-7.5 billion for taxpayers. We discuss various motives for the transaction, and argue that a major one is the need for short-term budget relief. Advance refunding enables the issuer to borrow for current operating activities in exchange for higher interest payments after the call date. We find that municipalities in states with poor governance generally destroy more value by advance refunding.

Keywords: municipal bonds, advance refunding, public finance

JEL Classification: G12, G28, H20, H24