Life Without Advance Refunding

Abstract

The elimination of advance refunding following the passage of the new tax law will have staggering effects on the municipal market. In recent years most municipal bonds aimed at institutional investors carried an above-market 5% coupon and had a 10-year call. Due to the overwhelming popularity of this structure, municipal benchmark curves represent the yields of AAA 5% NC-10 bonds. The 5% NC-10 structure had wide appeal for a variety of reasons, a primary one being their eligibility for advance refunding. Below, we will discuss in detail the appeal of this feature. For now, we simply observe that 5% bonds used to be routinely advance-refunded well before the initial call date in Year 10, to the benefit of issuers, investors, and the various intermediaries who facilitated such transactions. In the absence of advance refunding, the 5% NC-10 structure will lose much of its appeal. As a consequence, we expect structural changes in the municipal market. In particular, bonds callable in less than 10 years, with coupons below 5%, are likely to emerge. Because such bonds cannot be priced using 5% NC-10 yield curves, there will be demand for new benchmark curves. Issuers and their financial advisors will have to identify the most cost-effective funding alternative from among issues with different coupons and call provisions. A rigorous approach to determining the optimal time to call and refund will be another unfamiliar task. Meeting these challenges will require training in contemporary fixed income analysis, replacing the current ad hoc approaches to debt management.

Keywords: advance refunding, refunding efficiency, municipal bonds, call option, advance refunding option

JEL Classification: H74