When a municipality issues bonds, it is borrowing money at a certain interest rate for a certain period of time. This is not unlike a homeowner borrowing money in the form of a mortgage. For example, a homeowner borrows money at a certain interest rate for a certain period of time. When interest rates fall, most homeowners who have a mortgage choose to refinance that mortgage in the form of a lower interest rate. Perhaps they move from a 6% mortgage to a 4% mortgage to save money on interest. Similarly, a municipality may choose to refinance its debt to save interest costs for itself and the taxpayers who live in that municipality. This is called a refunding issue.
How does a municipality refinance its debt?
For example, when a municipality has outstanding bonds at 6% and interest rates have fallen to 4%, there is an opportunity for that municipality to refinance its debt and save money. Essentially, the municipality issues what is called a refunding issue of bonds, takes the money collected from that issue and places it into an escrow account which buys US Treasury bonds. The US Treasury bonds pay the principal and interest of the old 6% municipal bonds. The municipality then pays principal and interest on the new 4% bonds it just issued. Those old bonds are now backed by US Treasuries but continue to retain their federal tax exemption. Depending upon the type of refunding done, the old bonds are called escrowed municipal bonds or pre-refunded municipal bonds.
Escrowed or pre-refunded municipal bonds
Escrowed or pre-refunded municipal bonds, when they are escrowed in US Treasuries, are some of the highest grade, safest municipal bonds one can buy. After all, the principal and interest is paid by US Treasuries. However, even though they may be the safest bonds available, they may be available at a cheaper yield than many bonds that are not backed by US Treasuries. This is one of the anomalies of the municipal bond market.
Some things to watch out for with escrowed or pre-refunded municipal bonds
In the 1990s, some municipalities decided to use CDs, GICs (Guaranteed Investment Contracts), and other cheap market oddities as the escrow component of a refunding issue. Also, some municipalities that have callable bonds don’t defease their calls on escrowed or pre-refunded bonds. Be sure you, or your investment advisor who manages your portfolio, knows what to watch out for in the escrowed and pre-refunded bond space. These bonds can be very, very attractive, but like anything, the buyer needs to know the nuances of the market.
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