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Among the various types of financial structuring that is available to businesses and entrepreneurs is the concept of advance refunding. The process of engaging in advance refunding involves issuing new bonds that are used to repay the outstanding balance on older bonds before the call dates for the older bonds arrive. Here are some facts about the way that advance refunding is usually structured to ensure that the purchaser of the bonds and the issuer are protected.
Because the basic principle of advance refunding involves issuing new bonds to pay off outstanding bonds, there has to be some degree of security for the issuer. This is accomplished by using the proceeds from the new issue to invest in government securities, effectively placing the proceeds in escrow. The newer bonds are purchased at a rate that is lower than the longer-maturing bond that it pays off. The interest that is generated off the new bonds is used to pay for the long-maturity bond before the first call date arrives. In essence, this process is a means of pre-refunding the older bond.
Advance refunding is a common method used by local governments to delay the need to make payments of the outstanding bonds, while still maintaining current status with outstanding debt. This allows the government entity to spread out the total indebtedness over a longer period of time, rather than having to pay a large amount of debt in the present time. It is important to note that while municipal bonds are tax exempt, that status is revoked once the bond is used as part of an advance refunding strategy. The rationale of applying taxes to the bond is that in an advance refunding process, it is possible for the local government to issue a high amount of debt at lower rates. The local government can then invest the proceeds in investments that will pay off at a higher rate than the face value of the bond. Imposing taxes on the bonds helps to curtail the creation of an unreasonable amount of debt that could eventually lead to a financial crisis for the municipality.
While the use of advance refunding to pay off the outstanding balance on a long-maturity bond is sound, it is also a process that should not be abused. This pre-refunding process is a great way to allow a local government to temporarily reorganize debt so that it is more manageable. However, prudence in using advance refunding on an ongoing basis is recommended.