PRE-REFUNDED
MUNICIPAL BONDS
Pre-refunded municipal bonds offer significantly
high credit quality and liquidity making them a
highly sought after fixed income investment option.
Individuals seeking the tax advantages of
municipal bonds with the safety of U.S.
Treasuries may consider an investment in prerefunded municipal bonds. As their name implies,
these “pre-res” are refunded prior to their maturity
date and are paid off through an escrow account
which is typically funded by United States Treasury
securities until their call/maturity date. Combining
added safety and tax-free income make “pre-res”
a desirable choice for fixed income investors.
Pre-Refunded Municipal Bonds: At-a-Glance
• Payments are virtually equivalent in quality to Treasuries
because they come from the U.S. government after passing
through a binding escrow account.
• The liquidity of pre-refunded bonds is comparable if not
better than the liquidity of other municipal bonds in the
secondary market.
• Pre-refunded bonds maintain a tax-exempt status for federal
tax purposes.
An ideal investment for those seeking:
How are pre-refunded municipal bonds created?
These bonds are typically created when a bond issuer in a
municipality refinances outstanding debt to take advantage
of lower interest rates to reduce their financing costs. They
accomplish this by issuing “refunding bonds” whose proceeds
are used to buy securities that are placed in escrow and
dedicated to paying the interest and principal on the original
issue until it reaches maturity.
What are the benefits of pre-refunded municipal bonds?
In general, these bonds are known for their high credit quality
from escrowed securities that protect them. These securities typically consist solely of obligations that are directly
issued or guaranteed by the U.S. government—specifically,
U.S. Treasury bonds or State/Local Government Series bonds.
With Uncle Sam as the new backer of the debt, pre-refunded
bonds tend to carry the same high credit quality and minimal
default risk as Treasuries.
The quality of a pre-re is further enhanced by the structure
• A high level of credit quality
• Exceptional liquidity
• Relatively low price volatility
• Attractive tax-free income
of the escrow account which is pledged as security for bond
repayments and is managed by independent trustees. These trustees
are responsible for verifying that the size and timing of cash flows
are sufficient to meet interest and principal payments.
these bonds fluctuate in accordance to interest rate changes. It’s
also important to keep in mind that the escrowed securities backing
these bonds are used to pay interest and principal therefore do
not provide a guarantee of market price.
AAA rating
Pre-refunded municipal bonds are typically rated AAA because
they are backed by U.S. Treasury securities. Because of this, many
investors assume that their return will be low because of the high
credit quality. However, because these bonds generate tax-exempt
returns, an investor may be able to earn a higher taxable equivalent
yield than they would on a treasury security.
Taking into account all that pre-refunded municipal bonds have
to offer—including potential risks and rewards—they are still
considered one of the most advantageous fixed income investments
in the market today.
How liquid are pre-refunded municipal bonds?
Pre-refunded bonds constitute a very large segment of the municipal market. These bonds are heavily traded and generally stay
liquid even throughout turbulent times. However, this does not
mean they exhibit price stability on an absolute basis, but they
are more moderate than other types of municipal bonds.
Low price volatility
These bonds have short to intermediate maturities because they
are typically escrowed until their first call date. Given their relatively
shorter maturities, they exhibit less price volatility than those with
longer maturities.
par vs. premium
How pre-refunded bonds add up
The table below illustrates a hypothetical comparison between
a municipal bond priced at par and a pre-refunded municipal bond
priced at a premium.
Credit Rating
Coupon
$ @ call maturity
YTC/YTM
Purchase Price
...but risk can’t be completely eliminated.
While pre-refunded bonds are essentially free of credit risk, they are
subject to other risks typically associated with fixed income
securities, like interest rate risk, which means that the price of
Par Bond
Aaa/AAA
AAA/AA-
5.00%
3.25%
$100.00
$100.00
3.50% (YTC)
3.25% (YTM)
$106.26
$100.00
$106,215
$100,000
$100,000
$100,000
Interest (ten semi-annual
payments)
$25,000
$16,250
Net cashflow
$18,785
$16,250
Cost
Principal @ call/maturity
risk vs. reward
Rewards can be inherent...
As is with all investments, past performance can never be a
guarantee for future results. However, it is important to note the
impressive history pre-refunded bonds have offered investors. Most
notably, from 2005 through 2008, when the market was synonymous with volatility, pre-refunded municipal bonds outperformed
all broad segments of the tax-exempt and taxable U.S. bond markets—with the exception of U.S. Treasuries. In fact, these bonds
outperformed U.S. stocks.
Pre-Refunded
Based on the above example, the purchase of $100,000 face value
municipal bonds at par (3.25% due 1/1/2016) would earn $3,250
of tax-exempt income per year, or $16,250 over a five year period.
On the other hand, the same purchase of $100,000 face value
pre-refunded municipal bonds (5.00% pre-refunded to the call
date of 1/1/2016) would earn $5,000 of tax-exempt income per
year, or $25,000 over a five year period. Despite the pre-refunded
bond’s premium pricing, it yields $2,535 more in net cash flow
than the par bond.
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Moody’s and Standard & Poor’s (S&P) Rating Symbols & Definitions can be found on Moody’s and S&P’s respective websites at http://v3.moodys.com/ratings-process/Ratings-Disclosures/006016 and http://www2.standardandpoors.com/
spf/pdf/media/understanding_ratings_definitions.pdf. Additional information is also available upon request.
Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investment in lower-rated and non-rated securities presents a greater risk of loss to principal and
interest than higher-rated securities.
Securities and insurance products offered through Wayne Hummer Investments, LLC (Member FINRA/SIPC), founded in 1931. Trust and asset management services offered by The Chicago Trust Company, N.A. and Great Lake Advisors, LLC,
respectively. Investment products such as stocks, bonds, and mutual funds are not insured by the FDIC or any federal government agency, not bank guaranteed or a bank deposit, and may lose value. ©2014 Wintrust Wealth Management.
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