3.7.6 Refunding Bonds
Refunding obligations are any municipal debt obligations used to pay principal, interest and premium on other municipal debt (referred to in this section as “refunded bonds”). Principal on refunded bonds may have become payable for any reason, including maturity, mandatory redemption, or default acceleration, but refunding bonds are generally issued to pay refunded bonds that have been called for optional redemption. Further, refunded bonds may be redeemed optionally for a number of purposes, including covenant relief, asset release, and debt restructuring, but refunding bonds are generally issued and refunded bonds redeemed to save money on the debt service. See Section 2.3.1, Redemption or Prepayment. If current interest rates are significantly lower than those payable on the refunded bonds, public agencies can reduce debt service costs by replacing the refunded bonds with new, lower interest, cost refunded bonds. Public agencies often refund only the portion of the refunded bonds on which significant savings can be achieved.
Retirement of the refunded bonds generally occurs (1) shortly after the refunding bonds’ issue date, or (2) on the first date that the issuer may redeem the outstanding obligations. In a refunding transaction, the refunding bonds are issued to pay all or a portion of the interest and principal of the prior obligations, including redemption premium (if any). Bonds are advance refunding bonds if their proceeds are expended to pay principal, interest, or redemption premiums (if any) on the prior obligations more than 90 days after the refunding bonds’ issue date. Bonds are current refunding bonds if their proceeds are expended to pay the principal or interest on the prior obligations within 90 days after the refunding bonds’ issue date.
Since the Tax Cuts and Jobs Act of 2017 ended tax exemption for municipal advanced refundings, issuers’ options regarding refundings of tax exempt bonds are limited. Issuers seeking to refund tax exempt debt may consider other options, with the assistance of their municipal advisor, including taxable refundings or other debt structuring techniques to facilitate benefits similar to an advanced refunding.
LEGAL AUTHORITY – Statutes providing for bond issuance generally provide for refunding bond issuance. In addition, several statutes (e.g., California Government Code Sections 53500 et seq. and 53570 et seq.) provide general authority to public agencies to refund outstanding debt, including installment payment obligations under installment sale agreements, with refunding revenue bonds.
Issuing a refunding bond usually does not require voter approval, even if the issuance of the refunded bond did.
STRUCTURE AND DOCUMENTATION – Where an advance refunding is possible, the proceeds of the refunding bonds are generally used to purchase obligations (defeasance securities) of the type permitted by the terms of the outstanding debt to be used to “defease” the outstanding debt. See Section 2.4.10, Discharge and Defeasance. Defeasance securities generally are deposited in an escrow fund for the refunded bonds. The principal, interest, and redemption premium (if any) on the refunded bonds will then be paid from amounts derived from the defeasance securities on deposit in the escrow fund until the date on which the issuer may redeem the refunded bonds. Although the refunded bonds are still held by the bondholders until their call date and continue to be traded on the market, the indenture or bond resolution is legally defeased with respect to the refunded bonds, and the holders of the refunded bonds look to the escrow fund rather than the issuer’s revenues or other collateral for payment.
In a current refunding transaction, the refunding bonds’ proceeds are used to pay the principal of and interest on the refunded bonds on or shortly after the refunding bonds’ issue date. The refunded bonds generally are legally defeased, and the holders of the refunded bonds generally look to the escrow fund for payment.
A refunding escrow is generally established under an escrow agreement between the issuer and the trustee for the refunded bonds or according to a letter of instructions from the issuer to the trustee. The escrow agreement or letter of instructions provides for the establishment of an escrow fund, the deposit of money with the trustee, the purchase of the defeasance securities by the trustee and the application of amounts received with respect to the defeasance securities and other amounts in the escrow fund to the payment of the refunded bonds.
Defeasance securities may consist of U.S. Treasury Notes and Bonds – State and Local Government Series (SLGS, pronounced “slugs”), a special series of U.S. Treasury obligations designed to be used for refunding tax exempt debt or securities purchased on the open market (an “open market” escrow). In an “open market” escrow, if defeasance securities maturing on the precise dates on which amounts are needed to pay the refunded bonds are not available on the market, the escrow will be “inefficient.” Inefficiency can be addressed through the substitution of more efficient securities for the defeasance securities in the escrow or through instructions to the trustee to reinvest in other qualifying securities (if then available) between the date the original defeasance securities’ mature or pay interest and the date amounts are needed to pay the refunded bonds. For example, if the defeasance securities mature on May 15 and the refunded bonds are to be paid on July 1, the trustee can be instructed to reinvest proceeds of the defeasance securities received on May 15 in new qualifying securities maturing on or before July 1. Alternatively, the issuer’s right to reinvest can be sold (for money up front) under an arrangement commonly known as a “forward supply contract.”
OTHER CONSIDERATIONS – The Tax Cut and Jobs Act of 2017 amended the Internal Revenue Code of 1986 to prohibit the issuance of tax exempt advance refunding bonds. Issuing taxable advance refunding bonds may, however, still produce debt service savings. An issuer may issue current refunding bonds to refund either governmental bonds or private activity bonds. There is no limit on the amount of times a governmental bond issue or a private activity bond issue may be currently refunded. See Section 4.12, Refunding Bonds.