Don't Waste a Free Lunch: Managing the Advance Refunding Option

Abstract

A callable municipal bond issue funding a new project is usually eligible for “advance refunding”—that is, refunding between the issue date and the call date. Such refunding is accomplished by issuing new bonds, and investing the proceeds in an escrow portfolio of Treasury securities whose cash flows pay off the outstanding issue until the call date, when the old bonds are retired. Under favorable market conditions, advance refunding enables a municipality to lock in lower interest rates prior to the call date; waiting until that date would expose the issuer to the risk of higher rates. The right to advance refund is an option whose value depends not only on the issuer's borrowing rate, but also on Treasury rates, which determine the cost of the escrow portfolio. What makes this option (referred to by the authors as the “ARO”) unusual is that it is effectively a free lunch for the issuer. While investors pay a lower price for a callable bond, the price is not affected by the bond's eligibility for advance refunding. The free lunch is demonstrable when the yield of the escrowed Treasuries is higher than the issuer's funding rate to the call date. In such cases, the present value of the cash flows to the call date (which is how the market prices a deep‐in‐the‐money callable bond) exceeds the cost of the escrow. This excess effectively enables the issuer to retire the bonds below their fair market value. Another manifestation of the free lunch offered by advance refunding transaction occurs when the savings exceed the expected value of waiting—that is, when the value of the call option is less than the currently realizable savings. One important consideration when deciding whether and when to advance refund is that the ARO can be exercised only once in an issue's refunding life‐cycle. If an issue is advance refunded, its replacement cannot be. But if an issue is refunded once it becomes callable, the ARO stays alive in the replacement issue. In this article, the authors develop an analytical framework to help issuers deal with this problem. First, they explore how the value of the ARO depends on coupon, maturity, time to call, and prevailing Treasury rates. Then they use the results to make a recommendation about the advance refunding decision: act now or wait?. To answer this question, the authors extend the standard measure of refunding efficiency to incorporate the ARO of the replacement issue. Incorporating the ARO of the replacement issue slows down the signal to advance refund, whereas failure to do so could lead to a suboptimal decision. Near the call date, issuers may be better off locking in savings with a hedge rather than sacrificing the eligibility of the replacement issue for advance refunding.