Bond refundings are typically used to save money by refinancing to take advantage of lower interest rates. Bonds may also be refunded to eliminate certain covenants or obligations imposed on the issuer. In a current refunding, the refunding happens immediately: new bonds are issued within 90 days of the existing bonds being called, and proceeds from the new bonds are used to pay off the old bonds.
In some cases, however, the need for a refunding may occur before the bonds are eligible to be called. In this scenario, there are two outstanding bond issues for the same project. Because the existing bonds cannot yet be called, however, proceeds from the new bonds are not used to immediately pay off the existing bonds. Instead, they are set aside in an escrow account to be used to pay periodic interest on the existing bonds, plus principal when the original bonds eventually reach their call date and are redeemed.
The proceeds from the new bonds in the escrow are usually invested in very low-risk securities, such as State and Local Government Securities (SLGS) offered by the federal government. Although these securities have low yields, they nevertheless earn some income. The timing for receipt and the amount of the investment income is included in the calculation of the amount of refunding bonds that need to be issued to fund the escrow to pay interest and principal on the original bonds. The escrow is structured to have funds timely available to make principal and interest payments on the existing bonds.
In this way, the original, higher-rate debt is functionally replaced with new, lower-rate debt. The issuer now pays interest and principal on the new, lower-rate bonds from the same sources — e.g., taxes — used for debt service on the original bonds. Debt service on the original bonds, however, is paid out of the escrow with money from the new bond proceeds. From the issuer’s point of view, it is no longer responsible for the original bonds, which have been defeased: they are no longer recorded on the financial statements as a liability, and certain bondholder rights may be terminated (looking to the escrow and not the issuer for payment).
From the original bondholders’ points of view, they continue receiving scheduled interest payments on their bonds, with the understanding that the issuer has set in place the process to call the bonds when they reach their call date.
The federal government determined that some issuers abused the advantage of unlimited tax-exempt advance refundings and reduced the number of times an issue could be refunded on a tax-exempt basis. The federal Tax Cuts and Jobs Act of 2017 prohibited further use of tax-exempt advance refundings as of January 1, 2018. Although state and local governments may still advance refund their bonds, the new refunding bonds must now be taxable. As a result, the refunding bonds will likely offer higher interest rates, thereby reducing the money saved on interest payments. Even so, taxable advance refundings may still offer worthwhile savings in some cases.