What is Advance Refunding?
How Does Advance Refunding Work?
Let's assume interest rates have come down and City XYZ wants to refinance some outstanding municipal 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 , compliance and administrative tasks associated with the .
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 ; sometimes restrictions in covenants 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 , it does limit the 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 bonds, the purchases the Treasurys on behalf of City XYZ, marks up the price wildly, and sells the Treasurys to City XYZ's . Because the artificially raises the price of the , the goes down significantly. Thus, the illegally burns the down to a level that appears to comply with the federal law while making a substantial for itself.
burning diverts to 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 banks and financial institutions for this practice and has levied hundreds of millions of dollars in fines against them.