Some critical elements changed with the enactment of the Tax Cuts and Jobs Act of 2017 that may affect your next bond refunding. Specifically, a staple strategy referred to in the industry as a “tax-exempt advance refunding” was taken away. In a typical advance refunding, even when the call date for an outstanding bond issue may be several months or even years away, an issuer could still realize significant savings in a low interest rate environment by issuing new tax-exempt bonds to pay off those higher rate outstanding bonds.
The proceeds of the new bond issue would be placed into escrow and invested, with the invested principal and earnings used to provide for debt service payments on the outstanding bonds until the call date—and then, on the call date, pay those bonds off in their entirety.
This financing structure often provided issuers with an efficient way to take advantage of lower interests, provided that investment yields for the escrow were close to the yield on the bonds being refunded.
In fact, tax-exempt advance refundings accounted for approximately 30% of issuance volume in the municipal bond market prior to the Tax Cuts and Jobs Act. The elimination of this strategy left a significant void in the market and removed one of the most valuable tools from an issuer’s toolbox.
Fortunately, some creative solutions have emerged in the last two years to accomplish much of the same economic benefit that tax-exempt advance refundings previously provided. The following is a brief overview of three of them.
1. Refinance with a taxable bond
It may seem surprising for an issuer with access to the tax-exempt bond market to consider refunding outstanding debt with a taxable bond (which is not prohibited under the current tax law), but this approach may nonetheless offer significant savings. In fact, the strategy has already gained broad acceptance in the municipal bond community, and, absent another change in the tax code, it appears here to stay.
Although interest rates for taxable bonds are typically higher than comparable tax-exempt bonds, they allow issuers to lock in the savings today rather than waiting until the call date. Also, taxable bonds can be advance refunded in the future without restriction—potentially with a tax-exempt bond.
2. Cash defeasance / new money issuance strategy
Another alternative—one that can be attractive for issuers that use a pay-as-you-go approach for capital improvements—is a cash defeasance and new money issuance structure. This strategy involves using the cash that would otherwise be used to fund capital improvements over the next two to three years to legally defease (extinguish) higher-interest rate bonds that are not yet callable.
A new series of tax-exempt bonds with lower interest rates is issued simultaneously with the cash defeasance to finance those capital improvement projects over the next two to three years.
Assuming the new bonds are structured with a similar amortization schedule as the defeased bonds, but with a lower interest rate, the issuer may achieve comparable interest-rate savings as a tax-exempt advance refunding would have provided.
3. Issue a forward delivery bond
A third alternative is the issuance of forward delivery bonds. With these bonds, the interest rates for the refunding bonds are determined several months in advance of their closing date, which is scheduled to fall within the permitted window starting 90 days before the existing bonds’ call date.
To compensate purchasers for locking in interest rates several months in advance, they are provided with either a cash settlement or an interest rate premium. Doing so reduces the financial benefit from the refunding, but the strategy has nonetheless been used by several high-profile issuers recently. Depending upon the premium required to lock in the interest rates, forward delivery bonds can be a compelling option.
We are currently in a period of historically low interest rates, and if your organization has outstanding tax-exempt bonds that aren’t callable for several months or years, you may still have options to refund that debt even with the loss of tax-exempt advance refundings. One of the strategies we have discussed may be just the tool your organization needs to take advantage of these low interest rates and realize significant savings.
Within the UMB Bank Investment Banking Division, our public finance bankers provide public entities and private not-for-profit organizations with tax exempt and taxable financing solutions to help meet their capital needs across a myriad of project types. With decades of experience, our public finance bankers provide clients with professional guidance throughout the financing process.
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