What Is a Pre-Refunding Bond?

A pre-refunding bond is a debt security that is issued in order to fund a callable bond. With a pre-refunding bond, the issuer decides to exercise its ri♋ght to buy its bonds back before the scheduled maturity date.

The proceeds from the issue of the lower yield and/or longer maturing pre-refunding bond will usually be invested in 澳洲幸运5官方开奖结果体彩网:Treasuries (T-bill🐠s) until the scheduled call date of the original bond issue occurs💜.

Pre-Refunding Bonds Explained

An entity that is scheduled to call its existing bonds on a specified call date can choose to issue new bonds, of which the proceeds will be used to fulfill its inter✃est payments and principal repayments on the existing older bonds. The new bond that will be issued for this purpose is referred to as a pre-refunding bond.

Pre-refunding bonds are typically issued by municipalities, and are secured by high-credit quality investments. The new bonds are known as refunding bonds, and their proceeds are used to pay off the older bonds, referred to as refunded bonds. The refunded bonds are paid off at a predetermined date, hence, the term “pre-refunded” bond. Using pre-refunding bonds can be a good method for issuers to 澳洲幸运5官方开奖结果体彩网:refinance their older bonds when interest rates drop.

A 澳洲幸运5官方开奖结果体彩网:callable bond is one that can be “called” or repurchased from the secondary market by the issuer before the maturity date of the bond. When interest rates in the economy drop, bond issuers have an incentive to repurchase existing bonds that have higher affixed interest payments, and issue new bonds at the lower interest rates in the market. This reduces the issuing entity’s 澳洲幸运5官方开奖结果体彩网:cost of debt in the form of lower 澳洲幸运5官方开奖结果体彩网:coupon payments to bondholders.

However, to encourage investors to purchase callable bonds, these bonds usually have a 澳洲幸运5官方开奖结果体彩网:call protection that prohibits the issuer from calling t𝔍he bonds for a specific period of time, say five years. After those five years, the entity can exercise its rights to rep💎urchase the bonds from the market. The designated date after the call protection has ended that an issuer can call its bonds is referred to as the first call date.

Other Considerations

In anticipation of the future date when the old bonds will be repurchased, the proceeds from the new issues are held in escrow and invested in low-yield but high-credit quality vehicles, such as 澳洲幸运5官方开奖结果体彩网:cash investments or Treasury securities that mature around the same time as the original bonds. On the first call date or subsequent call dates, the funds held in escrow are used to settle interest and principal obligations to investors of the old bond. The interest accumulated from the Treasury securities pays off the interest fr𝔍om the pre-refunded bond.

Like most 澳洲幸运5官方开奖结果体彩网:municipal bonds, interest on pre-refunded bonds is exempt from 澳洲幸运5官方开奖结果体彩网:federal income tax and some state taxes. This tax benefit makes pre-refunded bonds an attractive investment option for investors in high-income tax bracke♐ts.

Example

For example, suppose that in June 2016, XYZ City decided to call its 9% callable bond (originally set to mature in 2019) for $1,100 on its first call date of January 2017. In July, XYZ City issued a new bond yielding 7% and took all the proceeds from that bond and invested them into T-bills, ensuring that enough money would be available t🌄o retire the issue come January.

The Bottom Line

A pre-refunding bond is a debt security that is issued by a corporation in order to fund a callable bond at a later date. Corporations use this pre-refunding strategy to effectively refinance their outstanding debt.