What is Pre-Funded Bond?

Pre-funded bond is a government issued, usually municipal, bond where the funds to pay it off at the call date are set aside in an escrow account.

Understanding Pre-Funded Bond

Pre-funded bonds are bonds which have their interest and 澳洲幸运5官方开奖结果体彩网:principal obligations guaranteed by risk-free securities in an escrow account. Investors are more likely to purchase this bond since there is a dedicated revenue source, almost like a guarantee, already in place for 澳洲幸运5官方开奖结果体彩网:coupon payments. Pre-funded bonds are issued by municipalities that wish to attain a higher credit rating for their debt. Since state-issued bonds are not pledged by the full faith of the U.S government, the underlying collateral minimizes the risk of default.

The pre-funded bond issuer is not required to generate cash flow to fulfill its payment obligations on the bond as the payment is made through the escrow account. The escrow is 澳洲幸运5官方开奖结果体彩网:collateralized by risk-free Treasury securities, such as 澳洲幸运5官方开奖结果体彩网:Treasury bills, which generate interest that is used to pay the coupons. The pre-funded bond and the U.S. securities tend to have the same maturity. The risk-free interest payment allows the issuing entity to set a lower 澳洲幸运5官方开奖结果体彩网:coupon rate on the bond than the rate on a comparable 澳洲幸运5官方开奖结果体彩网:zero-coupon bond. Thus, mun🌊icipal bond issuers benefit from pre🅘-refunding by reducing their long-term borrowing costs.

The 澳洲幸运5官方开奖结果体彩网:credit quality of a bond is determined by the level of risk the bond is perceived to have. A lower risk bond will have a higher credit quality and, thus, a higher 澳洲幸运5官方开奖结果体彩网:credit rating th🦹an a higher risk bond. Understandably, Investors are more drawn to higher rated bonds given that these bonds have ไa lower risk of default. So, to incentivize lenders to lend money, municipalities issue pre-funded bonds.

The price of pre-funded bonds fluctuates with movements in market rates. The bonds have 澳洲幸运5官方开奖结果体彩网:reinvestment risk but default-free coupon payments. Pre-funded bonds provide the tax advantages present in regular 澳洲幸运5官方开奖结果体彩网:municipal bonds, but are exposed to less risks. The federal government-based collateral reduces the potential for the issuer's credit to deteriorate. Still, pre-funded bonds are usually rated as 澳洲幸运5官方开奖结果体彩网:junk bonds given that they are sold primarily by entities that have little to no cash flow. If the funds in the escrow are tapped out before the bond matures and the issuer does not have enough cash to pick up the bond payments, there is a risk that the issuer could default. With the pre-funded structure, a company incurs the additional cost of creating the escrow fund and the 澳洲幸运5官方开奖结果体彩网:underwriting fees on the escrowed money.

Some pre-funded bonds are 澳洲幸运5官方开奖结果体彩网:defeased securities, that is, no longer recognized on the issuer’s balance sheet. Instead, the debt obligation is transferred from the issuer to the escrow fund. The securities used as collateral are sufficient to meet all payments of principal and interest on the outstanding bonds as they become due. If for some reason, the funds used for defeasance prove insufficientඣ to fulfill the future payment of the outstanding debt, the issuer would continue to be legally obligated to make payment on such debt from the pledged revenues. Pre-funded bonds that are defeased will have a provision in the escrow agreement requiring issuer on the pre-funded bonds to make up any shortfall in the escrow account, but this is unlikely.