By Todd Taves, Senior Municipal Advisor
and Brian Reilly, Senior Municipal Advisor | Managing Director

When interest rates decline, municipal bond issuers are often on the receiving end of unsolicited proposals to refinance debt, urging quick action so they don’t “miss this opportunity.” Before proceeding with a refinancing (known in public finance as a refunding), issuers should consult with their Municipal Advisor and closely consider a variety of factors.

Most municipal bond issues include an “optional redemption provision” or “call” feature that allows for pre-payment privileges at face value on and after a specific date. This “call date” is the earliest date that an issuer can elect to refund or prepay outstanding bonds. Most early redemption provisions permit prepayment in full, or in part, with 30 days’ written notice to bondholders. As an example, if an issue of bonds is callable on December 1, 2026, and an issuer wishes to exercise its option to call those bonds on the earliest possible date, a redemption notice must be transmitted to bondholders at least 30 days prior (and typically no greater than 60).

Whenever looking to preserve the tax-exempt status of any municipal bond issue through refinancing, there are important details that need to be adhered to.  The primary requirement in this regard is the refunding issue must close no sooner than 90 days prior to the call date of the bonds being refunded.  If the period between closing of the new bonds and redemption of the old ones is greater than 90 days, the new debt must be taxable.

Whether, and when, to refund prior bonds should be a conversation had with your trusted Municipal Advisor and take the following into consideration:

Are the potential savings significant enough to warrant refunding?

• One way to measure the attractiveness of a refunding is to calculate the present value of the projected savings as a percentage of the refunded bond’s principal outstanding.
• Present value savings of 2% or more of the refunded principal may warrant consideration, although savings of 3% is the minimum.  A lower savings threshold might be acceptable if the refinancing is part of a larger new money issuance, especially when the debt would not likely be viable to refund on a standalone basis.
• It is also important to remember that exercising the call feature does not require the issuer to redeem all the outstanding bonds of a given series. Selectively refunding the maturities of an issue of bonds that produce the greatest savings and leaving other maturities in place may produce greater economic benefit than refunding the entire issue.
• Some states impose minimum savings or other requirements related to refinancing prior debt issues, so be sure you confer with your Municipal Advisor about satisfying statutory requirements and any potential federal tax matters.

What are current and expected market conditions?

• In cases where a refunding analysis suggests that an issuer can achieve savings, it is also important to assess overall market conditions and the anticipated path of interest rates in both the near and medium term. In a declining rate environment, it may make sense to monitor the market and evaluate whether delaying a refunding could produce additional savings. A comprehensive analysis may also demonstrate that merely the passage of time in a stable rate environment will diminish savings, arguing for a more aggressive posture with respect to the calendar.
• All else equal, combining a refunding with a planned new money issuance will nearly always be advantageous to economize costs of issuance, enhance savings on the refinancing component, and potentially provide for an issuance with greater market appeal.
• While markets are unpredictable, your Municipal Advisor can help by quantifying how savings levels will increase or decrease based on movement in interest rates. This can be helpful in assessing the risk or reward of waiting.

Will restructuring provide any benefits?

• When an issuer undertakes a refunding to achieve debt service savings, one common approach is to structure the new debt so that the issuer realizes level annual savings over the original term of the refunded bonds.
• Refunding is also an opportunity to consider whether modifying the security, term or structure of the debt might provide additional benefit. For example, an issuer may want to increase or decrease annual debt service payments to better match projected cash flows associated with the source of debt repayment, such as a tax incremental financing district, or a public utility. Or, perhaps the governing body would like to reduce the tax impact of financing for capital projects through a combined refunding and new money issuance.
• When an issuer is contemplating restructuring, the maximum statutory term permitted for the type of debt, as well as any applicable covenants pertaining to revenue bond coverage, need to be considered. Further, extending the term of tax-exempt debt can potentially jeopardize the tax-exempt status of the new issue.

Are there other potential sources of funds available to pre-pay debt?

• When municipal debt is refunded, the new bonds will likely have a call date further into the future as compared to the original debt. For that reason, it is important for issuers to weigh whether achieving savings now is more beneficial than maintaining prepayment flexibility. As an example, an issuer may elect to not refund where the debt is paid from revenues of a tax incremental district that is expected to have sufficient cash on hand to pay off the debt in full within a few years.
• If there are available cash resources, consider whether it is more efficient for that cash to earn interest that might be greater than the interest rate on maturities subject to pre-payment. Additionally, cash can be invested to a target date that coincides with payment dates for bonds subject to optional redemption.  Your Municipal and Investment Advisors can review various scenarios to help identify the most economically efficient outcome.

Assessing all relevant factors will allow an issuer to make an informed decision as to whether, and when to consider refunding. Ehlers regularly monitors the outstanding debt obligations of our clients and provides periodic summaries of our refunding analysis. If you have questions related to the refunding potential of your existing debt, contact your Ehlers Municipal Advisor to discuss available options.

Important Disclosures: Please Read

Ehlers is the joint marketing name of the following affiliated businesses (collectively, the “Affiliates”): Ehlers & Associates, Inc. (“EA”), a municipal advisor registered with the Municipal Securities Rulemaking Board (“MSRB”) and the Securities and Exchange Commission (“SEC”); Ehlers Investment Partners, LLC (“EIP”), an investment adviser registered with the SEC; and Bond Trust Services Corporation (“BTS”), holder of a limited banking charter issued by the State of Minnesota.

This communication does not constitute an offer or solicitation for the purchase or sale of any investment (including without limitation, any municipal financial product, municipal security, or other security) or agreement with respect to any investment strategy or program. This communication is offered without charge to clients, friends, and prospective clients of the Affiliates as a source of general information about the services Ehlers provides. This communication is neither advice nor a recommendation by any Affiliate to any person with respect to any municipal financial product, municipal security, or other security, as such terms are defined pursuant to Section 15B of the Exchange Act of 1934 and rules of the MSRB. This communication does not constitute investment advice by any Affiliate that purports to meet the objectives or needs of any person pursuant to the Investment Advisers Act of 1940 or applicable state law. In providing this information, The Affiliates are not acting as an advisor to you and do not owe you a fiduciary duty pursuant to Section 15B of the Securities Exchange Act of 1934. You should discuss the information contained herein with any and all internal or external advisors and experts you deem appropriate before acting on the information.