What Are Prerefunded Bonds and How Do They Work?

Municipal bonds are often issued with long maturities, but issuers sometimes refinance them before their scheduled redemption date. Prerefunded bonds allow issuers to lower borrowing costs while ensuring bondholders receive timely payments.

Understanding how these bonds function requires examining the mechanics behind refunding, the role of escrow accounts, and the financial benefits involved.

Refunding Mechanics

When a municipality refinances its debt, it issues new bonds and uses the proceeds to pay off the old ones. This process, known as refunding, helps issuers take advantage of lower interest rates or restructure debt obligations. There are two primary types: current refunding and advance refunding. In a current refunding, the old bonds are retired within 90 days of the new bond issuance. Advance refunding, which was more common before the 2017 Tax Cuts and Jobs Act eliminated its tax-exempt status, involved setting aside funds well before the call date.

The decision to refund depends on financial factors such as interest rate differentials, call provisions, and present value savings. A key metric used to evaluate refunding feasibility is net present value (NPV) savings, which measures the difference between the cost of continuing to pay the old bonds and the cost of issuing new ones. Issuers generally aim for an NPV savings of at least 3% to 5% of the refunded bond principal to justify the transaction.

Beyond cost savings, refunding allows municipalities to manage debt service payments more effectively. By replacing high-interest bonds with lower-cost debt, issuers can free up budgetary resources for other projects and modify restrictive covenants in the original bond agreement, providing greater financial flexibility.

Escrow Arrangements

When an issuer refinances outstanding debt, the proceeds from the new bond issuance are securely held in an escrow account until they are used to pay off the original bonds. These accounts are typically structured as irrevocable trusts, meaning the funds cannot be withdrawn or repurposed.

The assets placed in escrow are selected to match the timing and amount of future bond payments. U.S. Treasury securities are commonly used due to their reliability and predictable cash flows. In some cases, state and local government securities (SLGS) may be purchased instead, as they are specifically designed for municipal bond escrows. The goal is to eliminate reinvestment risk by ensuring that the escrowed funds generate sufficient returns to cover all scheduled payments without exposing the issuer to interest rate fluctuations.

To comply with federal regulations, escrow accounts must be structured in accordance with IRS rules governing defeasance. Defeasance occurs when the original bonds are removed from the issuer’s balance sheet because the escrowed funds are sufficient to cover all obligations. This allows the issuer to issue new debt without the refunded bonds counting against their debt capacity, helping maintain creditworthiness.

Redemption Details

Prerefunded bonds are structured to be retired on a predetermined call date, set according to the original bond indenture. The call price is usually set at par or includes a small premium, depending on the original bond terms.

Callable bonds often include provisions dictating when and how they can be redeemed. For prerefunded bonds, the call date is locked in once the escrow is established, meaning issuers no longer control the timing of repayment. This differs from traditional callable bonds, where issuers retain flexibility in determining when to redeem the debt. Investors benefit from this certainty, as they can plan reinvestment strategies knowing exactly when they will receive their funds.

Market conditions influence how prerefunded bonds trade before redemption. Because they are effectively risk-free due to the escrowed funds, they often trade at a premium. However, if interest rates rise significantly, they may trade closer to par as investors seek higher-yielding alternatives.

Credit Enhancement

Investors assess a bond’s credit quality based on the likelihood of receiving full and timely payments, and prerefunded bonds benefit from structural features that strengthen their financial security. The presence of an escrow account holding U.S. Treasury securities elevates the creditworthiness of these bonds, often leading to a rating upgrade. Agencies such as Moody’s and S&P typically assign prerefunded bonds a rating equivalent to the securities backing them, which in most cases is AAA—the highest possible rating.

Higher credit ratings translate into lower yields, reducing the issuer’s borrowing costs on the new bonds. This allows municipalities to access capital markets at more favorable terms, freeing up resources for infrastructure projects, school funding, or other public initiatives. Investors benefit from a virtually risk-free fixed-income instrument that offers better returns than short-term Treasury notes while maintaining a comparable level of security.

Tax Implications

The tax treatment of prerefunded bonds depends on how they were structured at issuance and whether they comply with federal tax regulations. The 2017 Tax Cuts and Jobs Act eliminated the ability to issue tax-exempt advance refunding bonds, meaning any new advance refunding transactions must be done with taxable bonds. This change has reduced the prevalence of prerefunded bonds in the municipal market, as issuers now have fewer incentives to refinance debt unless market conditions strongly favor it.

For investors, tax implications depend on whether the bond retains its original tax-exempt status. If the prerefunded bond was originally issued as a tax-exempt municipal security and remains so after refunding, interest income remains free from federal taxes and, in many cases, state and local taxes. However, if the refunding bonds are taxable, investors must report the interest as ordinary income. Additionally, capital gains taxes may apply if the bond is sold before maturity at a price higher than its purchase cost. Tax-conscious investors often analyze the after-tax yield of prerefunded bonds compared to other fixed-income options to determine their relative attractiveness.

Accounting Methods

The accounting treatment of prerefunded bonds varies depending on whether an organization is the issuer or an investor. For issuers, the primary consideration is whether the refunded bonds qualify for defeasance, allowing them to be removed from the balance sheet. Under Governmental Accounting Standards Board (GASB) Statement No. 7, an issuer can derecognize the refunded debt if the escrowed funds are sufficient to meet all future obligations. This improves financial ratios and debt capacity, enhancing an issuer’s ability to secure future financing. However, issuers must disclose refunding transactions in financial statements, including details on the escrow arrangement and any economic gains or losses recognized.

Investors holding prerefunded bonds must account for them based on their classification within a portfolio. If the bonds are held to maturity, they are recorded at amortized cost, with interest income recognized over time. If classified as available-for-sale, they are marked to market, with unrealized gains or losses reflected in other comprehensive income. Institutional investors, such as insurance companies and pension funds, must also consider regulatory capital requirements when holding prerefunded bonds, as their high credit quality can influence portfolio risk-weighting calculations. Proper accounting ensures compliance with financial reporting standards while providing transparency into the financial health of both issuers and investors.