Advance Refundings of Municipal Bonds

59 Pages Posted: 20 Sep 2013 Last revised: 4 Mar 2023

See all articles by Andrew Ang

Andrew Ang

BlackRock, Inc

Richard C. Green

Carnegie Mellon University - David A. Tepper School of Business

Yuhang Xing

Rice University

Multiple version iconThere are 2 versions of this paper

Date Written: September 2013

Abstract

Municipal bonds are often "advance refunded." Bonds that are not yet callable are defeased by creating a trust that pays the interest up to the call date, and pays the call price. New debt, generally at lower interest rates, is issued to fund the trust. Issuing new securities generally has zero net present value. In this case, however, value is destroyed for the issuer through the pre-commitment to call. We estimate that for the typical bond in an advance refunding, the option value lost to the municipality is approximately 1% of the par value not including fees. This translates to an aggregate value lost of over $4 billion from 1996 to 2009 for the bonds in our sample, which are roughly half of the universe of advance refunded bonds that traded during the period. The worst 5% of the transactions represent a destruction of $2.9 billion for taxpayers. We discuss various motives for the transaction, and argue that a major one is the need for short-term budget relief. Advance refunding enables the issuer to borrow for current operating activities in exchange for higher interest payments after the call date. We find that municipalities in states with poor governance generally destroy the most value by advance refunding.

Suggested Citation

Ang, Andrew and Green, Richard C. and Xing, Yuhang, Advance Refundings of Municipal Bonds (September 2013). NBER Working Paper No. w19459, Available at SSRN: https://ssrn.com/abstract=2328505

Andrew Ang (Contact Author)

BlackRock, Inc ( email )

55 East 52nd Street
New York City, NY 10055
United States

Richard C. Green

Carnegie Mellon University - David A. Tepper School of Business ( email )

315B Schenley Park
Pittsburgh, PA 15213-3890
United States
412-268-2302 (Phone)
412-268-7064 (Fax)

Yuhang Xing

Rice University ( email )

6100 South Main Street
Houston, TX 7705-1892
United States

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