When is Saving Money Not a Good Idea?
The Pros and Cons of Advance Refundings
By Joel Sutter, Financial Advisor
When I was a new financial advisor at Ehlers 15 years ago, I called a
friend who was a very smart and experienced school business official. I
started my conversation by saying, “how would you like to be a big hero in
your school district and save the taxpayers a million dollars by refunding
your building bonds?” My friend actually laughed at me and said
something like, “I think I’ll wait a few years until we can save a lot more
money.”
We continued to monitor this issue as rates went up and down. Less than
two years later we were able to refund those same bonds and save the
district’s taxpayers over $4 million.
This experience - and hundreds of others since then - have helped me to learn a lot about how
bond refundings work. One key lesson is that saving what sounds like a lot of money now might
cost a district the opportunity to save a lot more later.
Refunding Basics
The basic concept behind refunding of municipal bonds is a lot like refinancing a mortgage –
your goal is to reduce payments by issuing new bonds with lower interest rates and using the
proceeds to pay off existing bonds with higher interest rates. Refunding can also be used as an
opportunity to restructure payment schedules (e.g., extend the payment schedule, shorten the
payment schedule, or decrease payments in some years more than others). But most school
districts use refundings primarily as an opportunity to reduce future payments and tax levies.
Municipal bonds, however, are a lot more complex than home mortgages, which makes bond
refundings more complex than refinancing a mortgage. One of the complexities is the “call
provision” which is established when bonds are initially sold. The call provision determines
which of the bonds can be prepaid, at what times, and at what price. A typical call provision on
school district bonds issued in 2005 might specify that bonds maturing in 2016 and later can be
called “at par” (at 100% of the principal amount) on February 1, 2015 or any date thereafter.
This means that bonds maturing earlier than 2016 can never be prepaid, and that the callable
bonds cannot be prepaid until the “call date” of February 1, 2015.
Two Basic Types of Refundings
There are two basic types of bond refundings – current refundings and advance refundings.
A current refunding is the simplest form of refunding, with the lowest up-front issuance costs;
it can only be sold within 90 days of the call date or later. So for our example, the bonds could
not be sold until November 4, 2014 or later. The proceeds of a new bond issue would be
invested by the district for up to 90 days (from the closing date on the new issue to the call date
on the old issue). On the call date, the invested funds would be used to call the existing bonds.
An advance refunding is any refunding for which the new bonds are sold more than 90 days
before the call date on the existing bonds. When interest rates are low, this can give a district the
opportunity to “lock in” low rates and guarantee savings, eliminating the risk that rates would
increase as the call date approached. However, there are more up-front issuance costs for
advance refundings, and additional restrictions under federal rules and state law.
The most common form of advance refunding used by Minnesota school districts is a “crossover
refunding.” With this form of refunding, the proceeds of the new bonds are placed in an escrow
account and invested in very safe investments (usually U.S. Treasuries or Agencies). The
escrow account is used to pay interest on the new bonds through the call date, and then to call the
existing bonds on the call date. The district continues making payments on the existing bonds
through the call date, and then “crosses over” to the payment schedule on the new bonds.
An advance refunding requires additional professionals not required for a current refunding (an
escrow agent, a CPA to verify the adequacy of the escrow account, and in some cases a bidding
agent for the securities in the escrow account). It may also increase the fees charged by the
financial advisor and bond attorney.
Advance refundings are also subject to additional legal requirements.
 Federal rules allow only one advance refunding on any debt issue (although multiple
current refundings are allowed) and place strict requirements on bidding of securities for
the escrow account.
 Minnesota State law allows advance refundings only if a minimum level of savings is
achieved (the present value of the savings must be at least 3% of the present value of the
refunded debt service.)
Current Barrier to Advance Refundings
In today’s rate environment, the biggest barrier to advance refundings is the low interest rates
available for investments in the escrow account. Returning to our example, let’s assume the
district has $22.5 million in bonds that are callable on February 1, 2015 and that the average
interest rate on new refunding bonds would be 2%. As stated earlier, the escrow account would
pay interest on the new bonds through the call date. Unfortunately, the best rate available on
U.S. Treasuries maturing on February 1, 2015 is around 0.35%. So each year, the district would
be “losing” about 1.65% of the balance in the escrow account, through what is called “negative
arbitrage.” If the district sold advance refunding bonds now, the total negative arbitrage would
be around $1 million. This would require the district to issue approximately $1 million in
additional bonds, and would significantly reduce the savings from the refunding.
Pros and Cons
Your most important job as a school official (and ours as a financial advisor) should be to weigh
the pros and cons of any financial decision, including whether to proceed with a refunding. If
we knew that interest rates were not going to change in the future, then a current refunding
would always save more money than an advance refunding, for three reasons.
1. The costs of issuance are lower for a current refunding.
2. A current refunding significantly reduces the cost of negative arbitrage.
3. The rates on the new refunding bonds would be lower for a current refunding, since the
bonds would be issued closer to their maturity date.
Of course, the big wild card is what will happen to interest rates as we get closer to the call date.
Current interest rates are very low by historical standards and there is no guarantee that they will
not increase.
So how do we decide whether to proceed with an advance refunding or wait until closer to the
call date? At Ehlers, we have developed what we call a “Sensitivity Analysis” which aids in
these decisions. A simplified example is shown below.
Sensitivity Analysis - Advance vs. Current Refunding
$29,000,000 G.O. School Building Bonds, Series 2004A
Call Date:
2/1/2015
Total Principal of Calable Debt:
$22,500,000
Existing Interest Rates:
4.50% - 5.0%
Date of Analysis: 6/1/2012
Advance Refunding
Dated:
8/1/2012
Estimated Savings:
Future Value of All Savings
Present Value as of 8/1/2012
PV Savings as % of PV of Ref. Debt
Present Value as of 12/1/2014
Current Refunding
Dated:
$1,186,675
970,702
4.152%
1,035,115
12/1/2014
Estimated Savings, Based on Current Interest Rates
Future Value of All Savings
$3,383,413
Present Value as of 12/1/2014
2,989,422
Present Value of savings, if interest rates change by:
-1.00%
4,399,093
-0.50%
3,665,987
Current Rates
0.00%
2,989,422
0.50%
2,285,677
1.00%
1,635,378
Break-Even Analysis
Estimated Break-Even Point:
1.47%
Ehlers estimates that, if interest rates increase by less than 1.47%
between now and 12/01/2014, then the district would gain greater
savings by waiting to conduct a current refunding than they would
receive from an advance refunding in the near future.
In this example, the sensitivity analysis shows the following.
1. An advance refunding now would produce almost $1.2 million in savings on future debt
service payments, with a present value of over 4%. (Sounds enticing, doesn’t it?)
2. If rates were exactly the same in the fall of 2014 as they are now, we estimate that a
current refunding would save almost $3.4 million.
3. Even if rates increased by a full percent, a current refunding in the fall of 2014 would
save over $1.6 million.
4. If rates increase by approximately 1.47%, then a current refunding in the fall of 2014
would likely save less than an advance refunding now.
In a situation like this, we often will meet with administrators and either the finance committee
or the full board to review and discuss the district’s options. We find that our clients have very
different views on how to proceed. Some practice a “bird in the hand” philosophy, saying things
like “if we can save a million dollars now, let’s grab it while we can.” Others are much more
patient, choosing to wait for an opportunity to maximize the savings to taxpayers. Either is a
perfectly acceptable course of action, as long as the district is making a well-informed decision
based on complete information.
Suggestions and Lessons
So what should you do if your financial advisor (or another financial firm) approaches you with
an opportunity for an advance refunding? Here are some suggestions.
1. Don’t be dazzled by what sound like very impressive savings now. With any refunding
opportunity, the goal should be to maximize the savings you can achieve.
2. Federal law limits you to one advance refunding on any issue, so you should be wary of
using that one opportunity up if the call date on your bonds is still several years away.
3. Ask your financial advisor to estimate the savings you would achieve if you waited to do
a current refunding, and ask them for the type of sensitivity analysis shown above.
4. Involve your school board in the discussion and decision regarding the refunding
opportunity. Refundings have both financial and political ramifications, and the Board’s
input is critical.
So when is saving money not a good idea? When you are giving up the opportunity to save a lot
more money later. For an honest analysis of refunding opportunities – and of the pros and cons
of proceeding now or waiting – contact any of the financial advisors on the Ehlers Education
Team.