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Federally tax exempt US Treasury bonds: pre-refunded municipal bonds

By May 29, 2019 No Comments

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. Another name for this practice is 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. This is an example where the municipality will issue a refunding issue of bonds. It 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. The old bonds are now backed by US treasuries but still retain their federal tax exemption.

Escrowed or pre-refunded municipal bonds

These old bonds are referred to as escrowed municipal bonds or pre-refunded municipal bonds. The title depends on the type of refunding done. Escrowed or pre-refunded municipal bonds are considered extremely safe. However, even though they may be very safe bonds, they may be available at a cheaper yield than other bonds 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. You or your investment advisor must know what to watch out for in the escrowed and pre-refunded bond space. These bonds can be very attractive, but like anything, the buyer needs to know the nuances of the market.

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