What Is a Refunding Bond and How Does It Work?

Governments and corporations issue bonds to raise money, but changing interest rates or financial needs can make existing debt less favorable. To address this, issuers replace old bonds with new ones through refunding, reducing borrowing costs or modifying repayment terms.

Refunding plays a key role in managing long-term debt. Understanding how it works is important for both investors and issuers, as different structures and legal considerations impact its effectiveness.

Key Elements

The success of a refunding bond depends on financial and structural factors that determine cost savings and feasibility. A key consideration is the interest rate environment at issuance. If current rates are lower than those on outstanding debt, issuers can refinance at a reduced cost. The difference between the old and new rates, known as the interest rate spread, directly affects net present value (NPV) savings, a key metric in evaluating whether refunding is worthwhile.

Call provisions in the original bonds also matter. Many municipal and corporate bonds include call features that allow early redemption after a set period. The call premium—an extra cost paid to bondholders—must be factored into savings calculations. If the call date is far in the future, issuers may need an escrow structure to hold proceeds until the bonds can be legally retired, adding costs and complexity.

The method of funding the escrow account also affects financial outcomes. Issuers often invest refunding bond proceeds in U.S. Treasury securities or State and Local Government Series (SLGS) bonds to generate predictable returns while complying with arbitrage regulations under the Internal Revenue Code. Tax rules impose limits on earnings from these investments, requiring careful structuring to avoid penalties.

Transaction costs, including underwriting fees, legal expenses, and credit rating agency charges, influence overall benefits. These costs can reduce potential savings, making a break-even analysis necessary to determine if refinancing is justified. Timing the issuance to align with market conditions is also important, as fluctuations in credit spreads and liquidity affect borrowing costs.

Types of Structures

Refunding bonds can be structured in different ways depending on when the new bonds are issued relative to the redemption of old debt. The chosen structure affects interest cost savings, escrow requirements, and tax treatment. The three primary structures are current, advance, and forward refundings.

Current

A current refunding occurs when new bonds are issued within 90 days of redeeming the outstanding debt. This structure avoids long-term escrow accounts and arbitrage restrictions. Since proceeds are used almost immediately to retire old bonds, issuers do not need to invest them for an extended period, reducing compliance burdens under tax regulations.

Under U.S. Generally Accepted Accounting Principles (GAAP), a current refunding is treated as an extinguishment of debt, meaning the old liability is removed from the balance sheet. Any difference between the carrying amount and the reacquisition price is recognized as a gain or loss in the income statement, affecting financial ratios relevant to credit analysis. Municipal issuers often prefer current refundings when interest rates have dropped significantly, as they achieve immediate savings without regulatory constraints.

Advance

An advance refunding occurs when new bonds are issued more than 90 days before the redemption of old debt. The proceeds are placed in an escrow account, typically invested in U.S. Treasury securities or SLGS bonds, until the original bonds can be retired. This structure was widely used by municipal issuers before the Tax Cuts and Jobs Act of 2017 eliminated the tax-exempt status of advance refunding bonds. As a result, most advance refundings now involve taxable bonds, which can reduce cost savings.

Under GAAP, issuers must determine whether the refunding qualifies as a debt extinguishment or a debt modification. If the present value of cash flows from the new bonds differs by more than 10% from the old bonds, it is considered an extinguishment, requiring derecognition of the old debt. Otherwise, it is treated as a modification, with the difference amortized over the remaining life of the debt. Issuers must also comply with arbitrage regulations, ensuring investment earnings in the escrow account do not exceed the yield on the refunding bonds, as excess earnings must be rebated to the U.S. Treasury.

Forward

A forward refunding involves issuing a commitment to sell refunding bonds at a future date without immediately delivering the proceeds. This structure allows issuers to lock in favorable interest rates before they can legally redeem existing bonds. Unlike advance refundings, forward refundings do not require an escrow account, as the new bonds are not issued until the redemption date approaches.

Forward refundings introduce risks, including interest rate and counterparty risk. Since bonds are priced in advance but issued later, market conditions can affect final costs. To mitigate this, issuers often use forward delivery agreements or interest rate derivatives such as forward-starting swaps. These instruments help hedge against rate fluctuations but introduce accounting considerations under Financial Accounting Standards Board (FASB) rules governing derivatives and hedging activities.

From a tax perspective, forward refundings can be structured as tax-exempt or taxable, depending on compliance with IRS regulations. If structured correctly, they allow issuers to achieve similar economic benefits to advance refundings without violating post-2017 tax law restrictions. However, these transactions require careful legal and financial structuring to ensure compliance with bond covenants and regulatory requirements.

Bondholder Considerations

Investors holding bonds subject to refunding must assess how the transaction affects their expected returns, liquidity, and reinvestment options. If a bond is called before maturity, investors receive their principal earlier than expected, which can disrupt long-term investment strategies. This premature redemption forces bondholders to reinvest at prevailing market rates, which may be lower, reducing overall portfolio yield.

Market conditions at the time of refunding determine whether bondholders benefit or lose from the transaction. If the original bonds were issued in a higher interest rate environment and are now being replaced with lower-yielding debt, investors may struggle to find comparable alternatives. Conversely, if market rates have risen since issuance, bondholders may be able to reinvest at higher yields.

Credit risk is another factor, as refunding can alter the issuer’s financial position. If new debt increases leverage or introduces unfavorable terms, bondholders may face heightened default risk. Credit rating agencies reassess issuers after a refunding to determine whether the new debt structure affects their ability to meet obligations. A downgrade can lead to price declines in both new and existing bonds, negatively impacting investors in secondary markets.

Legal and Contractual Requirements

Issuers must navigate a complex legal framework when executing a refunding, as federal securities laws, state statutes, and bond indenture provisions impose various obligations. The Securities Act of 1933 and Rule 15c2-12 of the Securities Exchange Act of 1934 require issuers of publicly traded refunding bonds to provide detailed disclosures, including official statements outlining financial conditions, risks, and transaction purposes. Failure to comply can lead to enforcement actions by the Securities and Exchange Commission (SEC).

State laws dictate whether and how municipalities can issue refunding bonds, often requiring voter approval or legislative authorization. Some states impose debt limits or prohibit extending maturities beyond the original bond term.

Credit Rating Factors

A refunding bond transaction can influence an issuer’s credit rating, as rating agencies assess how the new debt structure impacts financial stability and repayment capacity. If a refunding reduces interest costs and improves cash flow, it may lead to a rating upgrade, lowering future borrowing costs. Conversely, if new bonds extend maturities or introduce variable-rate structures that increase exposure to interest rate fluctuations, agencies may view the transaction as adding risk.

Tax Treatments

The tax implications of refunding bonds depend on whether the new issuance is structured as tax-exempt or taxable. The Tax Cuts and Jobs Act of 2017 eliminated tax-exempt advance refundings, requiring issuers to use taxable bonds for such transactions, increasing borrowing costs.

For corporate issuers, the deductibility of interest expense on refunding bonds is a key consideration. The Tax Cuts and Jobs Act imposed a limitation under IRS rules, capping net interest deductions at 30% of adjusted taxable income for certain businesses.