What is Advance Refunding?
Advance refunding occurs when a bond issuer, usually a municipality, invests the proceeds from the sale of new bonds in U.S. Treasurys with the intent of using the Treasurys to pay off the old bonds.
How Does Advance Refunding Work?
Let's assume interest rates have come down and City XYZ wants to refinance some outstanding municipal bonds. City XYZ doesn't issue the bonds on its own. Rather, it needs an underwriter (usually a department that is part of a much larger financial institution, such as an investment bank) to handle the logistics, compliance and administrative tasks associated with the offering.
One of these tasks is called advance refunding, whereby City XYZ invests the proceeds from the sale of the new bonds in U.S. Treasurys with the intent of using the Treasurys to pay off the old bonds. (Municipalities can't always pay off their bonds at will; sometimes restrictions in bond covenants mean they have to wait to actually send the checks out.) The underwriter purchases those Treasurys on behalf of City XYZ. This Treasury portfolio is called the escrow portfolio.
The federal government does not tax municipalities on the interest they pay on municipal bonds. But in order to make up for the lost revenue, it does limit the yield City XYZ can earn on its portfolio of Treasurys to no more than the yield on its new municipal bonds. Given that Treasurys yield more than municipal bonds in general, this can be an issue for City XYZ and the underwriter.
Why Does Advance Refunding Matter?
Advance refunding is common but can beget yield burning, which is the illegal practice of marking up municipal and/or Treasury bonds excessively in order to complete a bond offering. In order to comply with the rule that the yield on the escrow portfolio can't exceed the yield on City XYZ's new bonds, the underwriter purchases the Treasurys on behalf of City XYZ, marks up the price wildly, and sells the Treasurys to City XYZ's escrow fund. Because the underwriter artificially raises the price of the bond, the yield goes down significantly. Thus, the underwriter illegally burns the yield down to a level that appears to comply with the federal law while making a substantial profit for itself.
Yield burning diverts money to underwriters at the expense of the U.S. Treasury, and it jeopardizes the tax-exempt status of interest paid to holders of municipal bonds (and in some cases, the municipalities) associated with the practice. The SEC has prosecuted dozens of investment banks and financial institutions for this practice and has levied hundreds of millions of dollars in fines against them.